The Great Economists

by Linda Yueh

  She died at the beginning of the Thatcher era, which saw the rollback of Keynesianism. But despite being in and out of favour, Keynes has had an enduring impact on economics. It’s something that Keynes himself had predicted. The final passage of The General Theory reads:

  The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas … soon or late, it is ideas, not vested interests, which are dangerous for good or evil.29

  Keynes believed that there are no intractable economic problems, and that well-run economies would produce prosperity. Writing in 1930, he predicted: ‘the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not – if we look into the future – the permanent problem of the human race.’30

  It means that we can look forward to a fifteen-hour working week, as ‘three hours a day is quite enough’.31 But, it would lead to an even greater challenge:

  [M]ankind will be deprived of its traditional purpose … Thus for the first time since his creation man will be faced with his real, his permanent problem – how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.32

  CHAPTER 7

  Joseph Schumpeter: What Drives Innovation?

  Innovation is the engine of economic growth, or, as Joseph Schumpeter put it, innovation in a capitalist economy is the ‘perennial gale of creative destruction’.1 Schumpeter’s view was that the economy undergoes long cycles as new technologies are adopted, while existing technologies become obsolescent. And those new technologies give a boost to economic growth.

  Joseph Schumpeter was perhaps the first economist to define the ‘capitalist engine’, in his 1942 Capitalism, Socialism and Democracy, his most important work.2 Contrary to popular belief, the term ‘capitalism’ was not devised by Adam Smith. It is thought to have first appeared in The Newcomes, an 1854 novel by the author of Vanity Fair, William Makepeace Thackeray. According to the Oxford English Dictionary, Thackeray used the term capitalist to denote an owner of capital. Of course, Karl Marx referred to capitalism in his 1867 Capital, after which it was often used as an antonym for Marxism.

  According to Schumpeter, ‘Creative Destruction is the essential fact about capitalism.’3 He framed capitalism around his theories about how the capitalist engine powers the economy. The economy is in constant flux, affected by waves of technological innovation, which explains how countries become more productive and wealthier over time. In his view, ‘Stabilized capitalism is a contradiction in terms.’4

  For example the steam engine, electricity and, more recently, the computer have all transformed the way that we work. Such innovations raise productivity, which increases the growth potential of the economy. In contrast to Marx, Joseph Schumpeter aimed to be value-neutral and analytical, so that his research would not be affected by ideology. Instead of revolution, Schumpeter’s work delved into the details of the businesses responsible for path-breaking inventions and then explored the relationships between those innovations and the manner in which the economy and our living standards were improved by them.

  It helped that Schumpeter had experience in the business world as well as in economic policy. He was a lawyer and an academic in his twenties and Austria’s finance minister in his thirties, then became a banker before returning to academia. Although he made a fortune, he lost it all in a stock-market crash, which perhaps was a blessing in disguise, since it forced his return to economics. He eventually became a professor at Harvard University, where he wrote some of the most influential texts in the field.

  Based on his own career, Schumpeter saw bankruptcy and the obsolescence of some industries simply as part of the cycle of the economy whose growth had benefited millions of people. He observed on one occasion: ‘Practically every enterprise [is] threatened and put on the defensive as soon as it comes into existence,’5 and, on another: ‘It is the cheap cloth, the cheap cotton and rayon fabric, boots, motorcars and so on that are the typical achievements of capitalist production … the capitalist process, not by coincidence but by virtue of its mechanism, progressively raises the standard of life of the masses.’6

  But Schumpeter didn’t take the capitalist system for granted. He believed capitalism required vibrant entrepreneurship and prudent regulation. It was indeed an engine in that sense. Like a physical engine, capitalism required fuel, or it could break down.

  What would the creator of ‘creative destruction’ say about the innovation challenges that abound in the world’s major economies today? What would Schumpeter make of the challenge of innovating in a predominantly services, and increasingly digital, economy? That is the state of the UK, the US and most post-industrial economies, including Germany and others that may have retained a larger manufacturing base but whose services sector is still the largest part of their economies. And what would he have made of China’s innovation, which is an important factor in terms of whether it can join the ranks of prosperous nations?

  The life and times of Joseph Schumpeter

  Joseph Schumpeter was born in 1883 in Triesch, a small town to the south-east of Prague, in the Austro-Hungarian (or Habsburg) Empire. The empire was expansive, including today’s Austria, Hungary, Czech Republic, Slovakia, Slovenia, Croatia and parts of Poland, Ukraine, Italy and Romania. Both Schumpeter’s grandfather and great-grandfather were mayors as well as businessmen. In fact, the family textile business brought the first steam engine to the town.

  Schumpeter grew up at a time when the engine of capitalism was transforming society. The electric motor and internal combustion engine were dramatically changing the economy, much as the steam engine had done before. Along with the telephone and railways, these inventions increased economic growth and rendered old businesses obsolete.

  In 1901 the world’s three largest industrial firms were United States Steel, American Tobacco and Standard Oil. German companies, such as Krupp and Thyssen in steel, Siemens in electrical equipment and chemical giants Bayer, Hoechst and BASF had all become industrial powerhouses. But, in the empire, most people still lived on farms, while small businesses were losing out to cheaper products from industrializing nations such as America, Germany and Britain.

  German Austria’s per capita income in 1913 was only about half that of Britain, though twice that of Hungary. Most people had no access to indoor plumbing, clean water or mass-produced shoes and clothing. Telephones and central heating were available only to the wealthy. Austrian bureaucrats still handwrote documents even though typewriters had been in use for twenty years.

  Because Schumpeter had grown up during a time of vast change, his Harvard student and later economics Nobel laureate Paul Samuelson described him as ‘completely qualified to play the important sociological role of the alienated stranger’.7

  After Schumpeter’s father passed away when he was five, he moved with his mother to Graz, where one of the few universities in the Austro-Hungarian Empire was located. It was highly unusual for a young widow to move to another town. While there, she married a member of the Austrian nobility. He was a sixty-five-year-old retired general who was more than three decades her senior. The move to Graz and his mother’s second marriage meant Schumpeter could attend the best schools. He became fluent in six languages, including Greek and Latin. The family later departed for Vienna, where Schumpeter eventually attended the city’s prestigious university.

  At that time, German-speaking universities were among the best
in the world and the University of Vienna was among the top echelon for economics.8 Like other European universities at the time, Vienna’s economics professors were part of the Faculty of Law. Schumpeter’s degree, received in 1906, was not in economics but in civil and Roman law, which gave him knowledge of history. Later on, he practised as an attorney, which provided exposure to the business world.

  Unlike those economists who were interested in reforming public policy, the Austrian School strove to make economics more rigorous and move it away from politics altogether. This shaped Schumpeter’s concept of the subject. He believed that economics should be ‘neutral’ and free from politics, which compromised objective analysis.

  While studying, Schumpeter encountered the three leading approaches to economics. First, the Classical School, founded by Adam Smith and promulgated by David Ricardo and John Stuart Mill, among others. These largely English economists were actively involved with public policy. Schumpeter, though, criticized them for their lack of imagination: ‘Those writers lived at the threshold of the most spectacular economic developments ever witnessed. Vast possibilities matured into realities under their very eyes. Nevertheless, they saw nothing but cramped economies, struggling with ever-decreasing success for their daily bread.’9

  Despite his rejection of capitalism, and belonging to a school of thought of his own, Karl Marx was the only one who stressed the dynamics of a capitalist system, which left a mark on Schumpeter.

  The German Historical School, which detailed histories of various industries and institutions, also affected Schumpeter. Centred in Berlin, its leading economist was Gustav von Schmoller and its well-known sociologist was Max Weber, who wrote The Protestant Ethic and the Spirit of Capitalism. Schumpeter believed their school didn’t give enough credence to economic theory. But he admired Weber, who was willing to theorize as long as it was based on data, so they occasionally worked together despite the fact that the German and Austrian schools conflicted. Their common ground was the new doctrine of marginalism, investigating how individuals optimize their decisions to work and consume. In the final part of the nineteenth century, marginalism changed the foundations of economics, which ushered in an early version of the neoclassical revolution. W. Stanley Jevons, Carl Menger and Leon Walras are often quoted as the leading lights.

  The rise of the Austrian School cannot be separated from the particular history of the Austro-Hungarian Empire. The empire was vast, conservative and aristocratic. Its economic policy was dirigiste. It had been, and still viewed itself as, the most powerful state in Europe. It controlled almost all of central Europe and most of the important industries were kept in state hands or under tight regulation.

  The good side of this was that it had a large and meritocratic civil service, and key positions were held not by politicians but by professionals like Eugen Böhm von Bawerk in the Ministry of Finance, who rotated in and out of academia and the civil service. (Schumpeter was to follow in his footsteps, becoming finance minister in the post-war republic.) Such policies made the empire an important centre for economics. The society was very well organized and apparently quite stable.

  But the bad side, of course, was that everything was slow and sclerotic as well as resistant to change. There was no real economic freedom for entrepreneurs so the economy was failing to adapt and invest, falling seriously behind other European nations, particularly the upstart Prussians. Underneath the surface, there were growing social strains until the shock of the First World War destroyed the system.

  The Austrian School was a reaction to all this, hence their defining characteristics: entrepreneurship, anti-equilibrium and anti-planning. It was, as with all economic theories, rooted in its time. Just as Adam Smith reacted to the inefficiencies of eighteenth-century British government, the Austrian School reacted to the weaknesses of the nineteenth-century Austrian government.

  The Austrian School was led by Schumpeter’s professors. In 1905 Schumpeter enrolled in a seminar led by Menger’s former student Böhm von Bawerk, who was a three-time finance minister of imperial Austria. His classmates included Ludwig von Mises, who became one of the leading free-market economists of the twentieth century through his own writings and those of his pupil Friedrich Hayek.

  During his five years as an undergraduate Schumpeter published three articles. They appeared when he was just twenty-two. He wanted to pursue a career as both a professor and a public servant like his mentor, Böhm von Bawerk. But a lack of money and his middle-class background were impediments.

  His circumstances changed with marriage. In 1907, at the age of twenty-four, he wed Gladys Ricarde Seaver, the thirty-six-year-old daughter of a Church of England official. Gladys was upper class and their marriage propelled Schumpeter into the aristocracy, much as his mother’s second marriage had done for her.10

  Schumpeter discovered that he could work as a lawyer in Cairo, which was then effectively a protectorate of Britain, with no experience. It was not possible in Vienna or London to do so. The newlyweds moved there, and in ten months Schumpeter had earned enough to finance his family for years.

  They returned to Vienna, and in 1908 he published The Nature and Content of Theoretical Economics. The manuscript was his effort to reconcile the German Historical School with the Austrian marginalists in order to end the battle of Continental economics. It was similar to what Marshall had done when he synthesized the new marginalism with the old classical tradition of Smith and Ricardo.

  Although it didn’t sell well, the book contributed to his qualifications at the University of Vienna. Along with his examinations and delivery of the standard series of lectures, Schumpeter gained the certification to teach at any university in the Austro-Hungarian Empire.

  He had wished to stay in Vienna, but ended up at the University of Czernowitz in present-day Ukraine. Schumpeter hadn’t wanted to relocate to a remote city at the extreme eastern border of the empire, but he wasn’t there long. At the age of twenty-eight, he left to become the youngest professor of political economy in the empire at the University of Graz, which was second in size only to the University of Vienna.

  Schumpeter’s Theory of Economic Development was published soon after, in 1911. This was the book that made his name and it was to become one of the classics in economics. An English edition was later published by Harvard University Press in 1934 with the subtitle: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle. The ideas in this very early work formed the core of Schumpeterian economics, which were later developed in Business Cycles (1939) and the most popular of his books, Capitalism, Socialism and Democracy (1942).

  Schumpeter spent five months lecturing in America, which raised his profile, but soon after his return home the First World War broke out. Gladys had returned to England so was cut off from her husband. By 1920 he began to describe himself as unmarried, though the couple had not divorced.

  By the age of thirty-two, Schumpeter had written three significant books and twenty articles. His profile was further heightened by a lecture entitled ‘The Crisis of the Tax State’. In it, he criticized the tax regime, which he argued had reduced innovation by causing entrepreneurs ‘to migrate to countries of lower taxation’.11 He also highlighted how excessive demands for social services could weaken the capitalist system. It was after that lecture that he became Minister of Finance in Austria’s First Republic. It was rather unusual for a political novice to become a senior government official and at the age of thirty-six, but they were exceptional times. The First World War turned Austria almost overnight from the most historic, biggest and a stable state in Europe into one with dire economic prospects and on the brink of revolution.

  After leaving government in 1919, he wanted to stay in Vienna and live comfortably, so he became a banker and professional investor. He received a licence to operate the Biedermann Bank, which he viewed as compensation for his brief and challenging stint as finance minister.12 He even eventually resigned from the University of Graz in 1921.<
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  In his new occupation, Schumpeter gained insight into the role of banks in creating credit that could fund entrepreneurs. Between 1920 and the end of 1922 there was hyperinflation in Austria, despite which Schumpeter had managed to accumulated a significant fortune by the age of forty. But a year later, in 1924, Vienna’s stock market crashed, losing a staggering three-quarters of its value. Schumpeter suffered similarly, because he was reluctant to unload his stocks as their value fell. He remained loyal to even failing firms, especially the entrepreneurial ones. It seems even the creator of ‘creative destruction’ found it hard to let firms fail.

  Although he still had his position at the Biedermann Bank, Schumpeter fell into debt and was forced to resign. He ended up paying back the bank by borrowing from friends. It would take a decade before he was able to repay his debts. Having failed in both business and politics, Schumpeter himself epitomized the entrepreneurship that he would later write about.

  Not everything was dire. While all this was going on he had fallen in love with Anna Josefina Reisinger, whom he had known since she was a child. Anna was the daughter of the concierge of the apartment building in Vienna where he had grown up, and more than twenty years younger than Schumpeter. Her parents objected but when she turned eighteen, they reluctantly allowed her to accept Schumpeter’s proposal.13

  Schumpeter joined the prestigious University of Bonn, which meant that he had a stable source of income and they could marry. Neither set of parents were supportive, Schumpeter’s mother objecting to Anna’s working-class background while Anna’s parents were concerned about his age and his reputation as a womanizer. And then there was his marriage to Gladys, from whom he secured a civil waiver without her knowledge.

  They finally married on 5 November 1925, when he was forty-two and she was twenty-two and without their parents’ attendance. A year later, Anna died in childbirth, as did their baby son. His mother passed away around this time too. Schumpeter never escaped from the emotional stress of that year and buried himself in work.14 During his seven years in Bonn, he was prolific and published sixty-five articles. He also made money through penning popular pieces and lecturing to business audiences to pay his debts and send money to Anna’s parents, which he did for the rest of his life. True to his beliefs, he disliked prescribing policy remedies because it might compromise his objectivity. But, it was hard not to be involved during the 1930s. So, he wrote a series of articles as the world and Germany suffered from the Great Depression. He criticized bailouts of old or low-growth industries, but supported government intervention to help companies with strong growth potential. As a condition of public assistance, though, Schumpeter argued that they must adopt innovative practices.