Schumpeter's Theory of Economic Development

Journal of Insurance and Financial Management, Vol. 4, Issue 3 (2021) 65-81

Schumpeter’s Theory of Economic Development:

A Study of the Creative Destruction and Entrepreneurship Effects on the Economic Growth

Farrokh Emami Langroodi ^a,*

^aGoethe University Frankfurt, Graduate School of Economics, Finance, & Management (GSEFM), Department of Finance, Germany

ABSTRACT
ARTICLE INFO

This paper provides a multifaceted review and

analysis of Schumpeter’s Theory of Economic

Development and specifically the creative destruction effect intertwined with the business cycles, and their effectiveness in explaining the long-run economic growth by first, looking into the main features of this theory; second, comparing the fundamental similarities and differences of Schumpeter theory with respect to Marxism and

Keynesianism, third; a comparison of “Schumpeter” effect vs. the “refugee” effect in recently published

researches, and finally, the relationship of Schumpeterian and Kirznerian opportunities in modern entrepreneurship.

Article History

Submitted Accepted
11 Aug 2021 12 Aug 2021

13 Aug 2021

Available online

JEL Classification

A12 B13 B31 B52

Keywords

Schumpeter Creative Destruction Capitalism Kirznerian Marxism Keynesianism Economic Growth Business Cycle Entrepreneurship
Journal of Insurance and Financial Management
*Corresponding Author:

[email protected]

Author(s) retain copyright of the submitted paper (Please view the Copyright Notice of JIFM).

This work is licensed under a Creative Commons Attribution 4.0 International License .

Journal of Insurance and Financial Management (ISSN-Canada: 2371-2112)

Emami Langroodi F. / Journal of Insurance and Financial Management, Vol. 4, Issue 3 (2021) 65-81

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1. INTRODUCTION

It is well known that Joseph Alois Schumpeter always explained that “analyzing business cycles means neither more nor less than analyzing the economic process of the capitalist era” (Schumpeter, 1939). Consequently, his Theory of Economic Development - naturally embodies what today we would consider an integrated growth and cycle analysis. Starting with his early contributions to crises theory and business-cycle theory (Hagemann, 2003), Schumpeter strived continuously to understand the fundamental elements in the explanation of economic fluctuations. From his Theory of Economic Development (1911) until his monumental two volumes on Business Cycles (1939) and

Capitalism, Socialism and Democracy (1942), he mainly investigated the ways growth

and cycle dynamics communicate. The Schumpeterian system of economic thought was built in such a way as to realize a necessary symbiosis between economic, historical, political, social, and all other elements of the process of the functioning and development of the capitalist world. All of these specific aspects of capitalist society could be approached as separate entities because this was considered to be the most appropriate way to effectively access the economic aspects of reality (Croitoru, 2012). Certainly, from the Schumpeterian point of view, economic phenomena are not isolated and undetermined, but this is not a reason to explain the economic world through external factors. The Theory of Economic Development was the first step in this Schumpeterian effort to create the theoretical tools and concepts which were needed to approach the economic sphere of reality while assigning phenomena such as wars, political upheaval, and cultural or spiritual issues a secondary significance. The important influence of these latter is not effaced, rather Schumpeter succeeded elegantly in focusing the analysis of the economic development of the capitalist world on exclusively economic elements of the process. The central argument of his system of thought assigned the most significant role to Entrepreneurship with its inseparable and embedded innovative nature (Croitoru, 2012).

Schumpeter identified two main interaction channels (Croitoru, 2012). Business cycles, first are interpreted as the unavoidable joint-product of economic development dynamics. Schumpeterian competition drives innovation, but it also begets imitators, “swarms” of which copy their rival’s innovation, attracting investment, and leading to a boom.

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When the original innovator’s profit advantage is eliminated, investment moves elsewhere, and the sector may even shrink, until the next disruptive innovation, which restarts the cycle. However, the Great Depression seemed to challenge Schumpeter’s vision: why were entrepreneurs not jump-starting the economy? Schumpeter’s reply was the ponderous, unlovely Business Cycles (Schumpeter, 1939), a monumentally ambitious two-volume book that attempted nothing less than a history of capitalist processes, and that moreover, attempted to model business cycles as the product of interacting medium (40 months), long (8-10 years) and very long (50- 60 years) wave cycles. Schumpeter’s desire for exact economics led him to abandon the uncertainty and complexity of “irregularly regular” for the false precision of the three-cycle wave theory. Paul Samuelson said that the book “smacked of Pythagorean moonshine”.

Furthermore, he elaborated his famous process of Creative Destruction: the selective mechanism exerted in the recession and depression phases of the cycle which although it has a short-term negative impact, Schumpeter regarded as positive for long-run economic dynamics. Creative Destruction refers to the incessant endogenous mutation of the economic structure through the destruction of the old, established behavior and plans, and the creation of new ones by entrepreneurs. It is clear then that for Schumpeter growth and cycle dynamics are mutually influencing (Legrand & Hagemann, 2017). Creative destruction although certainly the most famous Schumpeterian concept is also rather complex, i.e., the outcome of a liquidation process and a reallocation of productive resources during a recession, and particularly a depression phase. Both mechanisms can have rather damaging economic consequences in the short run. For that reason, and also because of his earlier position on lack of justification for intervention to help the economy to escape the Great Depression, Schumpeter is generally considered a noninterventionist or a pure liquidationist (Legrand & Hagemann, 2017).

2. MAIN FEATURES OF THE THEORY OF ECONOMIC DEVELOPMENT

The main features of Schumpeter’s theory of economic development are as follows (Schumpeter, 1961):

1) Circular Flow 2) The Role of the Entrepreneur 3) Cyclical Process or Business Cycle 4) End of Capitalism

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2.1. Circular Flow

According to Schumpeter, in the first chapter of the Theory of Economic Development, “in a circular flow, from which we always start, the same products are produced every year in the same way. For every supply there awaits somewhere in the economic activities are repetitive”. It means that the supply and demand are in equilibrium at each point in time and the economy is in its stationary state. The circular flow is based upon a state of perfect competitive economy which is in a stationary state and there is perfect competitive equilibrium (Schumpeter, 1961).

The costs of the firms are equal to the receipts; the prices are equal to average costs. There are no profits no interest rates, no savings, no investment, and no unemployment. According to Schumpeter, this stationary equilibrium is characterized by the circular flow which continues to revive itself every year in the same system as the blood circulates in a human body.

As regards economic development Schumpeter in his theory states that “the development is a spontaneous and discontinuous change in the channels of the circular flow, disturbance of equilibrium which forever displaces the equilibrium state previously existing”. Schumpeter's theory of development is the key element of a dynamic process that consists of new resource combinations, so-called innovations, or technological changes. When innovations or changes (economic, social, political, and technical) take place in the economy, the stationary equilibrium or circular flow is displaced, and the process of development starts. These features imply that the circular flow is used in a static setting. To make it dynamic and consistent with development, changes must take place in the economic system. These changes can be brought through innovations.

Innovations may be defined as a change in the existing production system introduced by the entrepreneur to make profits and reduce costs. The innovation is closely linked with Schumpeter defined development as a “spontaneous and discontinuous change in the channels of flow, disturbance of equilibrium which, forever alters and displaces the equilibrium state previously existing” (Schumpeter, 1961).

He assumed that change is the basic element of a dynamic process and those changes come in the form of innovations. The innovations may consist of the following aspects:

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1. The discovery of the new source of raw materials. 2. The presentation of a new product. 3. The implementation of the modern method of production. 4. The search for new markets. 5. The creation of a monopoly or the establishment of a new type of industrial organization.

Schumpeter, thus, emphasizes the introduction of new products through the improvements in the technological and other economic and non-economic resources which lead to economic development.

2.2. The Role of the Entrepreneur as an Innovator

The entrepreneur is the key figure in Schumpeter’s analysis of the process of development. Schumpeter’s model starts with the breaking of circular flow with innovation in the form of a new product. He occupies the central place in the development process because he initiates development in a society and carries it forward. Entrepreneurship is different from the functions of a manager. A manager simply manages the affairs of an enterprise whereas the entrepreneur also takes a high degree of risk. The role of an entrepreneur has been glorified by Schumpeter based on functional abilities. According to him, entrepreneurs is to:

a. Appreciate the possibilities of innovation, b. Overcome the socio-psychological barriers against the introduction of new things, c. Direct the means of production into new channels, d. Persuade the banker to provide him with necessary finance for innovations, e. Induce other producers in his branch of activity for taking risks, f. Create an environment conducive to the satisfaction of wants as the normal motive, g. Provide leadership, and h. Take a high degree of risk in the economic world.

Though Schumpeter has given a comprehensive explanation of the role of the entrepreneur, it cannot be considered an adequate explanation of the general theory of capitalistic development. For entrepreneur himself is a product of the social environment, which compels him to innovate or get eliminated, because of the forces of competition. Despite

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this fact, credit goes to Schumpeter who has emphasized the role of an entrepreneur in capitalist development.

The entrepreneurs require two things to perform their functions. Firstly, there must exist technical knowledge with which the entrepreneur can introduce new products or new combinations of factors of production. This according to Schumpeter does not pose a problem because there always exists the reservoir of unused technical inventions, which can be explored and exploited by the prospective entrepreneurs; secondly, to carry out the new inventions, the entrepreneur requires the services of the factors of production. For this, she needs purchasing power in the form of credit and capital, which can be provided by banks and other financial institutions. Therefore, credit and banks play an important role in the economic development of a country (Schumpeter, 1961).

Role of profits: An entrepreneur innovates to earn profits. Profits are conceived, “as a surplus over costs – a difference between the total receipts and outlay – as a function of innovations” (Schumpeter, 1961). According to Schumpeter, under competitive equilibrium, the price of each product just equals its cost of production and, thus, there are no profits. According to him, profits arise on account of dynamic changes resulting from innovation. They continue to exist till the innovation becomes general.

Breaking the circular flow: The central theme of the Schumpeterian theory of economic development lies in the breaking up of the circular flow with innovation in the form of a new product by an entrepreneur raising the level of investment in the economy. The bank credit can help largely in this context (Schumpeter, 1961). Since investment in innovations is risky, the entrepreneurs must pay interest in it. Once the new innovations prove to be more profitable and quite successful, other entrepreneurs also follow them in ‘swarm-like clusters’. Innovations in one field may stimulate innovations in other allied fields. However, the trend of the expansion of innovations in other firms is never found to be 100%.

2.3. Cyclical Process or Business Cycle

The next component of development according to Schumpeter is the business cycle. To analyze the business cycle is to analyze the economic process under capitalism. Schumpeter’s approach to the business cycle or crisis is historical, statistical, and analytical. He believes that business cycles are not merely the result of economic factors

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but also of non-economic factors. Schumpeter concludes that crisis is the “process by which economic life adapts itself to the new economic conditions” (Schumpeter, 1961).

Bank credit is an essential element of Schumpeter’s model. According to Schumpeter, the creation of bank credit is assumed to accelerate money incomes and prices in the economy. It creates a cumulative expansion throughout the economy, with the increase in the purchasing power of the consumers, the demand for the products increases with supply. The rising prices and high rates of profits stimulate producers to raise investments by borrowing from the banks.

The secondary wave of credit inflation starts with the entrance of new entrepreneurs in the field of production which superimposes on the primary wave of innovations. This may be called “boom” or “prosperity”. Extreme optimism and speculation in business also further enhance prosperity.

During prosperity, new products start appearing in the market with the entrance of new entrepreneurs. These products displace the old ones and thus decrease their demand and in the market. Consequently, the prices of old products fall, intending to liquidate their stocks, the old firms start selling their goods at a low price and hence most of the firms incur losses. Investment declines and unemployment starts, leading to a fall in the aggregate demand. As the entrepreneurs start repaying bank loans, the quantity of money in circulation is reduced and prices start falling. Profits too decline and come to zero, uncertainty and risk increase. A wave of pessimism sweeps the entire economy, boom ends, and phase of depression starts.

Schumpeter believes in the existence of the long wave of upswings (boom) and downswings (depression). Once the upswing begins, ultimately, the economic force of recovery comes into operation and brings about a revival, once again the economies come across new equilibrium, and the new boom period starts.

2.4. End of Capitalism

Like Karl Marx, Schumpeter also believes that capitalism is self-destructive. He stated, ”there is inherent in the capitalist system a tendency towards self-destruction, those factors make not only for the destruction of the capitalist system but for the emergence of socialist civilization” (Schumpeter, 1961).

Schumpeter agrees with the Marxian thesis that capitalism has itself the seeds of its own

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destruction and ultimately it will come to an end. The very success of capitalism will bring about its decay.

Three noticeable forces are the beginning of the creeping death of capitalism. They are:
1. The decadence of the entrepreneurial function, 2. The disintegration of bourgeoisie family, and 3. The destruction of the institutional framework of the capitalist society.

The tendency towards concentration into big concerns weakens and destroys the twin institutions of private property and freedom of contract. According to Schumpeter, “capitalism cannot survive; it will die on its own accord”. It will ultimately give place to

socialism”.

3. SCHUMPETERIAN VS.MARXISM AND KEYNESIANISM

3.1. Who is the Hero?

In political economy, the tragedy is a genre of the “growth” story, which is to be contrasted with the “equilibrium” story. All equilibrium narratives end in the same place; in equilibrium. Growth stories, in contrast, are more open-ended, uncertain, and pathdependent. In growth stories, history matters. Even tragedies, which also end predictably, must tell the beginning first. Thus, the political economy’s best-known growth stories provide a hero (McCraw, 2009).

Adam Smith’s hero was the prudent man. Commercial society depends upon the prudent man, who behaves virtuously even when it is in his material interest to do otherwise.

Marx, too, wrote in the growth genre. So, even Marx’s determinism – wherein capitalism necessarily seeds its own destruction – found room for a hero: the radical intellectual. Never mind that the death of capitalism was preordained: it is the radical intellectual who can pierce the veil of his false consciousness to correctly see the truth of historical inevitability, and it is the radical intellectual who can lead the vanguard of proletarian revolt (McCraw, 2009).

For John Maynard Keynes, the hero was the economist qua expert. The hero economist sees the folly of crushing war reparations, and the error of Say’s Law, and urges upon the powerful a new law -- that prudent monetary and fiscal stimulus can restore traction

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to aggregate demand temporarily mired in a liquidity trap (McCraw, 2009). Schumpeter was not averse to Keynes’ economist-as-hero construct. But Schumpeter thought that Keynes’ stagnationist ideology provided intellectual cover to those far more hostile to capitalism than he and that Keynes’ emphasis on the short run invited trouble from governments naturally inclined to profligacy and incompetence (McCraw, 2009). It was naïve, Schumpeter believed, to hope that the state would do what its economic experts tell it to do. And government fecklessness to one side, what if the experts have got it wrong?

Schumpeter’s hero, of course, was the entrepreneur, “the agent of innovation,” and, Schumpeter said, “the pivot on which everything turns” (McCraw, 2009).

3.2. Schumpeter vs. Marx

It is well-known that Schumpeter postulated an “inevitable decomposition of capitalist society” (Schumpeter, 1942). “Can capitalism survive?” he asked pointedly. “No, I do not think it can” (Schumpeter, 1942). Capitalism's prospective demise is not perceived to emanate from “its breaking down under the weight of economic failure ....” Instead, “its very success undermines the social institutions which protect it, and inevitably creates conditions in which it will not be able to live, and which strongly point to socialism as the heir apparent” (Schumpeter, 1942). In short, the “paradoxical conclusion” is not the result, but the process: “capitalism is being killed by its achievements” (Schumpeter, 1942). Popular expositions generally present a sharp dichotomy between the themes of Marxian contradiction (“capitalism cannot survive because of economic failure”) and the Schumpeterian paradox (“capitalism is being destroyed because of its very creative success”).

The “essential point to grasp” about capitalism, according to Schumpeter, is that it is an “evolutionary process,” as “was long ago emphasized by Karl Marx.” Capitalism is “by nature a form or method of economic change and not only never is but never can be stationary” (Schumpeter, 1942). This evolutionary dynamic of capitalist development has three salient characteristics: It comes from within the economic system and is not merely an adaptation to exogenous changes. It occurs discontinuously rather than smoothly. It brings qualitative changes or “revolutions,” which fundamentally displace old equilibria and create radically new conditions. Economic development is accompanied by growth, i.e., sustained increases in national income. As Marx expressed it in the Communist Manifesto the