Schumpeter and Business Cycles

In the paragraphs below, I attempt to both summarize McGraw’s description of Schumpeter’s contribution to business cycles and add a few comments  as to where his reasoning might help us interpret a post 1950 world.

For many years, Schumpeter focused his scholarly attention on understanding the ups and downs in the economy known as business cycles.  He viewed these ups and downs as part and parcel of the dynamics of capitalism, which could not be understood without paying specific attention to the institutions through which capital flowed.  The two volume 1,095 page magnum opus entitled Business Cycles captures Schumpeter’s look into virtually every nook and cranny of the dynamics of capitalism in the U.S., the U.K. and Germany.  Although he apparently left few stones unturned in this voluminous study, many reviewers concluded that he was not very successful in distinguishing between the forest (of cyclical dynamics) and the trees (of specific institutions in particular countries.)

One Schumpeterian conclusion, however, did come through with incredible clarity: “…theoretical equipment, if uncomplemented by a thorough grounding in the history of the economic process, is worse than no theory at all (254).”  Although Schumpeter would approve of the mathematical precision that modern economics has sought as well as of the empirical confirmation or rejection offered by econometric techniques, he would be aghast at economic analysis without either capitalists or entrepreneurs.  For him, both economic growth and business cycles – which must be closely linked in the study of capitalism – required the entrepreneur as innovator whether it be through new processes (including physical and virtual factories), new forms of organization (such as corporations and partnerships) and new forms of financing (including well developed bond markets, seller financed purchases, and a vibrant market for venture capital.)

The entrepreneur is Schumpeter’s protagonist in the modern history of both business cycles and capitalism, which cannot be easily separated from one another.  He envisioned an entrepreneur driving disruptive change through product or process innovation that made existing technology and processes uncompetitive, and thus, generated strong economic and political reaction from those whose sources of income would be severely pinched.  He was quite concerned about the ability of Luddies, and other opponents to structural economic change, to construct barriers to the entry of entrepreneurs and new competition.  Although not posited as such, he understood  that “rent-seeking” through the establishment of barriers to entry through the capturing of politicians was a necessary downside to both business cycles and capitalism.

Schumpeter also was concerned about legalized monopolies that might block entrepreneurial initiative, but he seemed optimistic that the gains (profits) from innovation would be sufficiently large to attract many competitors and thus limit the power of these monopolies.  Such “competing down” ensured that monopoly profits would not be sustainable.  He cites repeal of the anti-cotton laws in 1774 in Britain as evidence that the fruits of technological change, as characterized by the power loom for example, would be recognized as generating vast improvements in social welfare.

Although invention and new technology were important to Schumpeter, organizational innovation was at least as important.  McGraw highlights Arkwright’s development of the factory system as a critical contribution to capitalistic dynamics as it enabled entrepreneurs to achieve scale economies and a division of labor such as that envisioned by Adam Smith (in the Wealth of Nations.)  Germany in the latter half of the 19^th century, and perhaps Japan in the latter half of the 20^th century, exemplifies the power of the accumulation of capital.  Britain did not allow such scale to arise, and as a result its textile industry stagnated.

One might posit that Schumpeter’s dynamics of capitalism would recognize that falling in love with scale economies for its own sake, and building barriers to technology that would compete with it, would generate its own form of stagnation.  Modern industrial economies have certainly not fully learned the Schumpeterian lesson that failure is as important part of the capitalist dynamic as success is.

Schumpeter cites the development of railroads in the United States as a quintessential example of capitalistic dynamics.  He views the development and shakeout in the railroad industry as fundamental to the rise of efficient forms of transport of goods and people in the United States.  Furthermore, the capital intensive character of railroads meant that few capitalists (or capitalists qua entrepreneurs) would be able to raise the funds on their own to backstop such large scale development.  I find his discussion of the underpinnings of the “joint stock company” as particularly persuasive; entrepreneurs created a new institution that did not depend on the founders of the organization, limited liability to invested capital, did not require new legislation, and, most importantly for Schumpeter, allowed for the separation of ownership from management of expansive enterprises.  Such a view helps us recognize why Schumpeter distinguished capitalists from entrepreneurs (a distinction that escaped Marx) and also gave rise to the professional management.  One might view the rise of management consultants (such as Deloitte, Accenture, McKinsey, and the Boston Consulting Group) as the obvious next stage in both specialization and the evolution of capitalism according to Schumpeter.

Schumpeter knew that capitalism would create a very disruptive process with much collateral damage.  He, however, envisioned both continuous innovation and enlightened regulation as both a brake on the power of monopolists and ensurer of continuous economic progress.  Such progress, by the way, required a vision of future that featured a less burdensome lifestyle (GE’s all electric kitchen) and even gracious living (Herb Kohler’s mantra.)

Schumpeter noted the interactive character of major innovations in the first half of the 20^th century.  In particular, he cited how innovations in steel production led to innovations in the automotive industry which led to innovations in financing.  Furthermore, these actions had to be in the right order.  Cheaper steel led to cheaper cars which could be sold to the average household if credit (provided by GMAC and others) would then be forthcoming.  Many of the technical changes that he described can be matched with Kondratieff cycle of 50 to 60 years.

Despite the power of Schumpeter’s ideas, his impact on economics paled in comparison with that of his contemporary John Maynard Keynes.  From a macroeconomic perspective, the battle was between Keynes’s simple aggregate model, which focused on total demand for goods and services, and Schumpeter’s much more complex innovation model with all its fits and starts.  Over the middle portion of the 20^th century, Keynes’ view held sway both because it was coherent and easy to understand and because it offered a solution as to how to both escape from and prevent a depressed economy.  Schumpeter’s argument not only did not contain a response to depressed economies, it was delivered in a style that was not easy to fathom except for the very informed and diligent reader.

Insufficient aggregate demand and deficient animal spirits might have been compelling 60 years ago; today, they are much less so.  Since the late 1970s, macroeconomists have sought a return to a microeconomic basis for modeling economic aggregates.  For the most part, such explanations still have not incorporated roles for entrepreneurs or institutional change, but the literature has begun to become more Schumpeterian.  For example, endogenous growth theory introduced by Paul Romer, has looked for innovative ways to explain productivity growth.  His explanations require not only require an economy with some non-competitive elements but explicit attention to invention and innovation and that’s why many economists have turned back to Schumpeter