WEBVTT NOTE 13. Schumpeter’s Theory of Economic Development 1 00:00:00.000 --> 00:00:06.140 Chapter 13 Schumpeter's Theory of Economic Development 2 00:00:06.140 --> 00:00:11.680 Josef R. Schumpeter always took the middle ground in areas of politics and academics. 3 00:00:11.680 --> 00:00:17.080 His work cannot be readily categorised even today. He felt himself obliged to the Austrian 4 00:00:17.080 --> 00:00:22.280 School on the one hand, and when he got to Harvard, was happy to introduce American students 5 00:00:22.280 --> 00:00:28.040 to Austrian teachings. But he also made all kinds of concessions to socialism, holding 6 00:00:28.040 --> 00:00:34.520 the German Historical School and Gustav Schmoller in particular in high esteem in the 1920s. 7 00:00:34.520 --> 00:00:39.120 When he was 28, he tried to weave together these different traditions in the later famous 8 00:00:39.120 --> 00:00:44.680 Theorie der wirtschaftlichen Entwicklung 1912, The Theory of Economic Development. 9 00:00:44.680 --> 00:00:49.280 As a starting point, he applied the equilibrium theory of Lausanne economist Leon Walrass 10 00:00:49.280 --> 00:00:56.280 1834-1910, which stands in marked contradiction to the thinking of the Austrian School. 11 00:00:56.280 --> 00:01:01.000 Unlike Walras, however, Schumpeter was of the view that a static theory alone was insufficient 12 00:01:01.000 --> 00:01:03.800 to fully explain economic phenomena. 13 00:01:03.800 --> 00:01:08.180 In the preface to the Japanese edition of his Theory of Economic Development, he noted 14 00:01:08.180 --> 00:01:12.640 that one would have to assume a source of energy within the economic system that would 15 00:01:12.640 --> 00:01:17.980 upset the equilibrium of economies, as external factors alone could not be made responsible 16 00:01:17.980 --> 00:01:20.000 for such a change. 17 00:01:20.000 --> 00:01:25.040 Furthermore, in his strongly psychology-biased description of the role of entrepreneurs, 18 00:01:25.040 --> 00:01:29.420 Schumpeter drew on the groundwork of the Berlin political economists Adolf Friedrich Johann 19 00:01:29.420 --> 00:01:37.820 Riedl 1809-1872 and Albert Eberhard Friedrich Schäffler, neither of whom, however, he cited. 20 00:01:37.820 --> 00:01:41.660 Schumpeter's German, Original Theorie der wirtschaftlichen Entwicklung, has been published 21 00:01:41.660 --> 00:01:46.540 nine times to date. It has been translated into numerous languages, including Italian, 22 00:01:46.540 --> 00:01:52.480 French, Polish, Brazilian, Japanese, Russian, Slovak and Hungarian, with a considerable 23 00:01:52.480 --> 00:02:22.260 The book was received in the Anglo-American world in the form of an abridged, rewritten, 24 00:02:22.260 --> 00:02:27.780 and imprecise translation from 1934, also based on the second edition, The Theory of 25 00:02:27.780 --> 00:02:33.420 Economic Development, 1934. The remarkable consequence is that the original text remains 26 00:02:33.420 --> 00:02:38.960 largely unknown to this day. Indeed, Schumpeter's name is linked in many cases to theses which 27 00:02:38.960 --> 00:02:44.780 he had explicitly opposed in his original work. Schumpeter, who proceeded on the assumption 28 00:02:44.780 --> 00:02:50.180 of a categorical distinction between static and dynamic economics, stated from his second 29 00:02:50.180 --> 00:03:08.980 These changes would come about while implementing new combinations of production goods, the 30 00:03:08.980 --> 00:03:14.340 manufacturing of a new product, for example, or the introduction of a new production method, 31 00:03:14.340 --> 00:03:19.300 the opening up of a new market, access to a new source of natural resources, or the 32 00:03:19.300 --> 00:03:26.240 The creation or breaking of a monopoly. These processes of industrial mutation, which continuously 33 00:03:26.240 --> 00:03:30.940 revolutionise the economic structure from within, wrote Schumpeter, amount to a process 34 00:03:30.940 --> 00:03:37.300 of creative destruction, and constitute the essential reality of capitalism. To be in 35 00:03:37.300 --> 00:03:42.740 a condition of dynamic imbalance is in the nature of capitalist markets. Old structures 36 00:03:42.740 --> 00:03:49.220 are periodically replaced by new. If a capitalist society were in equilibrium, it would be doomed. 37 00:03:49.220 --> 00:03:54.860 In this sense, innovation and creative destruction are its pivotal features. 38 00:03:54.860 --> 00:03:59.720 It is ultimately the entrepreneurial will, the entrepreneur's leadership, that spurs 39 00:03:59.720 --> 00:04:04.780 on economic growth and social change. Schumpeter stated in the original German edition that 40 00:04:04.780 --> 00:04:09.440 entrepreneurs even force their products onto the market, but in the fewest of cases our 41 00:04:09.440 --> 00:04:14.180 entrepreneurs themselves also create it. It is not part of the entrepreneur's function 42 00:04:14.180 --> 00:04:41.300 In the first volume of his Business Cycles, 1939, German Konjunkturzuchen, Schumpeter 43 00:04:41.300 --> 00:04:46.500 Miser repeated that without doubt the great majority of changes in commodities consumed 44 00:04:46.500 --> 00:04:51.780 has been forced by producers on consumers. In most cases the consumers would have resisted 45 00:04:51.780 --> 00:04:57.580 and would have first had to be educated by elaborate psychotechnics of advertising. Railroads 46 00:04:57.580 --> 00:05:01.740 did not emerge because some consumers took the initiative in displaying an effective 47 00:05:01.740 --> 00:05:06.980 demand for their service in preference to the services of mail coaches. Nor did consumers 48 00:05:06.980 --> 00:05:29.560 The English version of this passage dissented slightly from the German original in that 49 00:05:29.560 --> 00:05:34.340 it omitted the naïve and quixotic undertone in the character sketch of the entrepreneur. 50 00:05:34.340 --> 00:05:38.420 Apart from that, a quintessence was preserved in the translation. 51 00:05:38.420 --> 00:05:43.300 First of all, there is the dream and the will to found a private kingdom, and usually, though 52 00:05:43.300 --> 00:05:45.860 not necessarily, also a dynasty. 53 00:05:45.860 --> 00:05:51.420 Then there is the will to conquer, the impulse to fight, to prove oneself superior to others, 54 00:05:51.420 --> 00:05:55.100 to succeed for the sake of success itself. 55 00:05:55.100 --> 00:05:58.960 From this aspect, economic action becomes akin to sport. 56 00:05:58.960 --> 00:06:02.020 There are financial races, or rather boxing matches. 57 00:06:02.020 --> 00:06:10.020 Finally, there is the joy of creating, of getting things done, or simply of exercising one's energy and ingenuity. 58 00:06:10.020 --> 00:06:21.020 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. 59 00:06:21.020 --> 00:06:27.020 Our type seeks out difficulties, changes in order to change, delights in ventures. 60 00:06:27.020 --> 00:06:31.020 Schumpeter's fundamental distinction between entrepreneurs and their imitators, 61 00:06:31.020 --> 00:06:36.140 Leaders, those he called mere managers, can be traced back to the leadership elite theory 62 00:06:36.140 --> 00:06:38.740 of his teacher Friedrich von Mises. 63 00:06:38.740 --> 00:06:43.900 According to Mises, only people of a very special kind occupy an exceptional position 64 00:06:43.900 --> 00:06:49.220 by having the courage to innovate and the desire to form the world in their image. 65 00:06:49.220 --> 00:06:53.660 They play the part of the trendsetter in the world of fashion, but also as founders of 66 00:06:53.660 --> 00:06:58.900 joint stock companies, as leaders of political parties or as strike leaders. 67 00:06:58.900 --> 00:07:04.060 Leading and following, writes Wieser, is the basic form of all social action. 68 00:07:04.060 --> 00:07:09.180 Mises do not unite because of contracts, they unite through leading and following. 69 00:07:09.180 --> 00:07:13.100 Although Wieser understood leadership in terms of social function rather than in terms of 70 00:07:13.100 --> 00:07:17.300 people's drives or character traits, Schumpeter placed special emphasis, even in the first 71 00:07:17.300 --> 00:07:21.380 edition, on the psychological profile of the business leader. 72 00:07:21.380 --> 00:07:26.100 The psychological side of the entrepreneurial portrait was tied unmistakably to Friedrich 73 00:07:26.100 --> 00:07:34.900 Nietzsche, 1844-1900, and also to Max Weber's 1864-1920 Charismatic Leader, or Oswald Sprenglas, 74 00:07:34.900 --> 00:07:41.260 1880-1936, Faust-like human being, bringing to mind the emerging leader cult in Germany. 75 00:07:41.260 --> 00:07:45.800 In the first, German edition Schumpeter saw the entrepreneur as analogous to the creative 76 00:07:45.800 --> 00:07:50.820 artist and thinker, or described him as chieftain specialising in business matters, but from 77 00:07:50.820 --> 00:07:55.380 the second edition on he placed more emphasis on the function of the entrepreneur. 78 00:07:55.380 --> 00:08:01.000 What he depicts is an elite that enjoys flaunting its accomplishments and strengths, and moulds 79 00:08:01.000 --> 00:08:06.420 social reality, casting a spell over it with restless ambition. Members of this elite can 80 00:08:06.420 --> 00:08:11.140 be found among property owners or company founders, but the leading man might also be 81 00:08:11.140 --> 00:08:17.000 a manager, a majority share owner, or even someone who has no capital at his disposal. 82 00:08:17.000 --> 00:08:21.420 It is leadership rather than ownership that matters. 83 00:08:21.420 --> 00:08:25.660 In order to produce something innovative and to offer it on the market, an entrepreneur 84 00:08:25.660 --> 00:08:30.980 would have to withdraw already existing production goods from their previous use. For this purpose, 85 00:08:30.980 --> 00:08:36.340 he would need purchasing power, but he seldom possesses the needed investment capital. The 86 00:08:36.340 --> 00:08:40.940 entrepreneur does not usually save up to acquire the necessary means, nor does he accumulate 87 00:08:40.940 --> 00:08:45.500 any goods before beginning to produce, so funding is necessary in order to introduce 88 00:08:45.500 --> 00:08:59.500 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. 89 00:08:59.500 --> 00:09:11.500 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. 90 00:09:11.500 --> 00:09:17.420 The entrepreneur, writes Schumpeter, is never the risk-bearer. The one who gives credit 91 00:09:17.420 --> 00:09:23.180 comes to grief if the undertaking fails. Risk-taking is in no case an element of the entrepreneurial 92 00:09:23.180 --> 00:09:28.380 function. Even though he may risk his reputation, the direct economic responsibility of failure 93 00:09:28.380 --> 00:09:33.980 never falls on him. It applies that the lender, the banker, simply transfers purchasing power 94 00:09:33.980 --> 00:09:39.740 yet by no means actual stock. In the original German version, Schumpeter had still noted, 95 00:09:39.740 --> 00:09:45.380 somewhat unassertively that one could say without any great sin that the banker creates 96 00:09:45.380 --> 00:09:51.540 money. Later in the English edition this self-absolution was retained. After the second German edition 97 00:09:51.540 --> 00:09:56.520 Schumpeter refined the language of his explanatory model even further. It is always a question 98 00:09:56.520 --> 00:10:01.380 not of transforming purchasing power, which was already in someone's possession, but 99 00:10:01.380 --> 00:10:05.900 of the creation of new purchasing power out of nothing. This is the source from which 100 00:10:05.900 --> 00:10:19.140 With the help of loans, an entrepreneur could crush the attempts of others and establish 101 00:10:19.140 --> 00:10:24.500 his new products on the market. This would provide him with substantial profits. Since 102 00:10:24.500 --> 00:10:29.300 he has no competitors when the new products first appear, the determination of their price 103 00:10:29.300 --> 00:10:34.700 proceeds wholly or within certain limits, according to the principle of monopoly price. 104 00:10:34.700 --> 00:10:39.340 But his success would soon attract imitators. His profit margin would in turn decrease and 105 00:10:39.340 --> 00:10:45.300 soon give way to the competition. The entrepreneur's profit slips from the entrepreneur's grasp 106 00:10:45.300 --> 00:10:49.700 as soon as the entrepreneurial function is performed. It attaches to the creation of 107 00:10:49.700 --> 00:10:55.980 new things, to the realization of the future value system. It is at the same time the child 108 00:10:55.980 --> 00:11:01.280 and the victim of development. The appearance of imitators taking advantage of the pioneering 109 00:11:01.280 --> 00:11:06.640 The work of the entrepreneur would on balance cause an economic boom. This would be evident 110 00:11:06.640 --> 00:11:11.400 in the creation of new jobs, on the one hand, and in wage increases and a higher interest 111 00:11:11.400 --> 00:11:16.800 rate on the other. But this would also result in a decrease in the demand for credit, and 112 00:11:16.800 --> 00:11:22.120 many of those new companies, in contrast to established ones which can fall back on accumulated 113 00:11:22.120 --> 00:11:28.000 resources, would go bankrupt. In other words, the wave of innovation would again subside, 114 00:11:28.000 --> 00:11:33.260 where the economy would slide into crisis. After a period of economic recession, innovative 115 00:11:33.260 --> 00:11:39.900 entrepreneurs would again emerge in some branches of industry and the cycle would begin anew. 116 00:11:39.900 --> 00:11:44.580 The idea that the modern economy is mainly financed with the help of credit had been 117 00:11:44.580 --> 00:11:49.900 discussed years earlier by Rudolf Hilferling in Boehm-Bawerk's seminar. Hilferling published 118 00:11:49.900 --> 00:11:54.300 the same, but Schumpeter made no reference to it, even at the time critics thought it 119 00:11:54.300 --> 00:11:59.940 It was easy to prove empirically that innovations were indeed not, or by no means exclusively 120 00:11:59.940 --> 00:12:05.740 financed by debt. All in all, Schumpeter's theory of economic development enjoyed a mixed 121 00:12:05.740 --> 00:12:11.460 reception. He later remarked that the book had been rejected generally. Schumpeter's 122 00:12:11.460 --> 00:12:16.760 denial of capital interest in static economics and his thesis of the inflationary financing 123 00:12:16.760 --> 00:12:21.820 of innovative production processes elicited displeasure on the part of his former teacher 124 00:12:21.820 --> 00:12:26.420 Eugen von Boehm-Bawerk, who in a lengthy critique warned against the danger of false teaching 125 00:12:26.420 --> 00:12:32.340 presented in such a disarming manner, full of spirit and eloquence. Schumpeter's meek 126 00:12:32.340 --> 00:12:37.340 response and Boehm-Bawerk's rejoinder showed all too clearly how deep the rift between 127 00:12:37.340 --> 00:12:42.820 Schumpeter and the Austrian School had grown. After the First World War, the Austrian School 128 00:12:42.820 --> 00:12:48.360 got to the bottom of the link between credit financing and business cycles. Unlike Schumpeter, 129 00:12:48.360 --> 00:12:54.320 members saw in the creating of purchasing power out of thin air a beguiling illusion 130 00:12:54.320 --> 00:12:59.160 that would undermine and ultimately distort the workings of the economy. 131 00:12:59.160 --> 00:13:03.600 Schumpeter's Theory of Economic Development nevertheless enjoyed a remarkable renaissance 132 00:13:03.600 --> 00:13:06.560 in the last decades of the 20th century. 133 00:13:06.560 --> 00:13:12.360 It served as the inspiration for what is called evolutionary economics and also modern research 134 00:13:12.360 --> 00:13:14.060 on innovation. 135 00:13:14.060 --> 00:13:20.460 With his work Capitalism, Socialism and Democracy 1942 written during the Second World War, 136 00:13:20.460 --> 00:13:24.460 Schumpeter dedicated himself among other things to the question of whether capitalism can 137 00:13:24.460 --> 00:13:30.540 survive in the long term. Schumpeter answered in the negative, large corporations would 138 00:13:30.540 --> 00:13:35.700 take on the role of innovator more and more, key decisions would no longer be made by ambitious 139 00:13:35.700 --> 00:13:41.660 small entrepreneurs driven by their desire for social advancement but by paid managers. 140 00:13:41.660 --> 00:13:46.340 of Lively Contact between all people and things involved in production. Schumpeter had already 141 00:13:46.340 --> 00:13:53.300 written in Socialistische Möglichkeiten von heute, 1920-1921, Socialist Prospects of Today, 142 00:13:53.300 --> 00:13:58.340 there would be ever more administration from some distant boardroom, and the capacity for 143 00:13:58.340 --> 00:14:03.540 technical innovation increases with the size of the company. It will be systematically 144 00:14:03.540 --> 00:14:09.220 undertaken by research and development departments of large businesses. Finally, in the late 145 00:14:09.220 --> 00:14:13.820 Capitalist era business administrators whose actions generally resemble those of civil 146 00:14:13.820 --> 00:14:19.300 servants rather than innovative entrepreneurs would drive the economy. Everywhere we find 147 00:14:19.300 --> 00:14:24.660 industries which would not exist at all but for protection, subsidies and other political 148 00:14:24.660 --> 00:14:30.220 stimuli and others which are overgrown or otherwise in an unhealthy state because of 149 00:14:30.220 --> 00:14:36.140 them. The classic entrepreneur will be left with no arena in which to operate. Bureaucratic 150 00:14:36.140 --> 00:14:40.900 Capitalism will slowly metamorphose into centrally planned socialism.