by Linda Yueh
Despite these challenging times, Schumpeter witnessed the impressive wholesale reinvention of business, which fed into his theory of ‘creative destruction’ where the innovators flourish. Small and medium-sized German businesses, mostly family owned, upgraded their operations and became known globally for their quality. Many of these Mittelstand companies are still around today, for example Hohner harmonicas, Krones labelling machines and the Jil Sander fashion label.
Big businesses also reinvented themselves. Five of Germany’s ten largest firms manufactured steel at the time of his move to Bonn. By the time he left, several had merged to become Vereinigte Stahlwerke (United Steelworks), which was the biggest steel and mining company in Europe.
As his prolific research raised his profile, Schumpeter received numerous academic offers, including one from Harvard University. A good salary at an elite economics department led Schumpeter to accept a one-year visiting appointment from 1927–28 while maintaining his position at Bonn. As is common among those taking up visiting positions, Schumpeter found that he liked Harvard better and eventually accepted a permanent post in 1932. Given his stature, Schumpeter received the maximum salary for Harvard professors, which allowed him to send money regularly to friends and former students in Europe and pay his remaining debts in Vienna.
It was during this time that Schumpeter established the Econometric Society in 1930, along with the Norwegian economist and co-recipient of the first Economics Nobel Prize Ragnar Frisch and Yale’s Irving Fisher. They wanted to promote the use of mathematical and statistical methods in economics, which Frisch named ‘econometrics’. Schumpeter wrote the lead article for the society’s first issue of Econometrica, which began publication in 1933 and remains a leading journal today.
Not all professors enjoy both teaching and research, and arguably few are great at both. Schumpeter was one of the rare exceptions. He organized several small discussion groups, including the Schumpeter Group of Seven Wise Men, who were rising stars. This group included the best of the Harvard Economics Department: Douglas V. Brown, Edward Chamberlin, Gottfried Haberler, Seymour Harris, Edward Mason, Overton H. Taylor and, his favourite, the future Russian Nobel laureate Wassily Leontief.15 His students included stars such as America’s first Nobel laureate in economics Paul Samuelson, who would correct Schumpeter’s mathematical errors.
An engaging figure in public, Schumpeter was a popular teacher. But in private, he suffered from anxiety and despondency, and made his research the focal point of his days. As Schumpeter himself proclaimed: ‘My work is my only interest in life.’16 He even graded himself daily on his productivity, for example 0, 4/6, 0, 0, 1/3, 5/6, 1 for a weekly mark of just 50 per cent.17
But not all aspects of academic life suited Schumpeter. He disliked departmental meetings and referred to his colleagues as the ‘fools’ (a play on the German pronunciation of ‘full’ professors) and ‘asses’ (associate and assistant professors).18
After Adolf Hitler became Chancellor of Germany in 1933, Schumpeter became an active recruiter for American universities, working to secure places for German, particularly Jewish, economists. By the inter-war period many had left Vienna and the university’s economics faculty was in decline.
Around that time, Schumpeter met Romaine Elizabeth Boody Firuski, a thirty-five-year-old graduate student in economics at Harvard who came from a prosperous old New England family. In 1920 she had received the first summa cum laude degree from Radcliffe College, the all-women sister college to Harvard. After an unhappy marriage had ended, she returned to Cambridge, Massachusetts, and worked as a research assistant for Schumpeter and others, and resumed writing her dissertation on English trade. He became her co-supervisor and she received her PhD from Radcliffe in 1934. Though he was fifty in 1933, and she was fifteen years younger, she was an intellectual partner and soon she became more. They married in New York in August 1937; his third marriage and one that lasted until his death in 1950.
Schumpeter’s trio of major works was completed at Harvard: Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process in 1939, Capitalism, Socialism and Democracy in 1942 and History of Economic Analysis, which was published posthumously in 1954.
Although he had laboured over Business Cycles, it did not receive widespread acclaim. This was a disappointment to Schumpeter, since he had spent seven years writing what he thought would be his seminal work. To make matters worse, at a Harvard seminar that his students organized to discuss it, they ended up talking about John Maynard Keynes’s recent The General Theory of Employment, Interest and Money. Schumpeter’s wordiness contrasted with Keynes’s succinct prose, which may have also contributed to the students’ choice. Several remarked that it was the only time they ever saw Schumpeter so angry.19
Ever since the 1936 publication of Keynes’s magnum opus, the English economist had outshone Schumpeter. Keynes did not make much mention of the business cycle research of Schumpeter or other Continental European economists. In return, Schumpeter disputed even the title of the book, specifically the ‘general’ part, since he believed that Keynes’s theory applied only narrowly to an economy in depression.20
What the General Theory did was offer a new explanation of the Great Depression that outlined a way forward for the world economy. By contrast, Schumpeter did not believe in prescribing economic policy, consistent with his long-standing view that politics compromised objective economic analysis. In the Preface to Business Cycles Schumpeter wrote: ‘I recommend no policy and propose no plan.’21 That hurt the appeal of the book at a time when the public was seeking answers to the worst economic downturn in history.
Schumpeter had been active in European economic policy before, so he was not without opinion. Although he was not a fan of FDR’s New Deal and he opposed Keynes’s fiscal activism funded by deficit spending, Schumpeter believed that America needed public investment. In 1933 unemployment rose to a staggering 25 per cent. After falling with the introduction of the New Deal, it rose again to over 17 per cent in 1939, after the second recession of that decade. It was then that he started writing the book that would leave his mark on the subject. Capitalism, Socialism and Democracy began as a series of essays, which reacted to a time of turmoil. It encompassed the Great Depression, the rise of Marxism that challenged capitalism and the Second World War.
It was published in 1942, but due to the Second World War it wasn’t until the second (1947) and third (1950) editions that Capitalism, Socialism and Democracy became prominent. The book struck a popular nerve since it captured the great debate of the period. At that time, 40 per cent of the global population was living under communism and another quarter or so in at least partly socialized economies.
Schumpeterian economics
Joseph Schumpeter’s most influential work addressed fundamental questions about how an economy operates. Schumpeter wondered if capitalism was doomed to fail, as argued by Marx. If socialism replaced capitalism, would the economy prosper? The third part of the title refers to whether there would be democracy alongside either capitalism or socialism.
Schumpeter makes the case emphatically for capitalism. He argues that people’s lives had improved tremendously because of ‘creative destruction’:
The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as US Steel illustrate the same process of industrial mutation – if I may use that biological term – that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.22
Schumpeter’s firms were not powerless to influence the economic environment, in stark contrast to standard economic models. In using the term ‘business strategy’, Schumpeter challenged the assumption of ‘perfect competition’, where all firms are identical, and sell homogeneous products, so have no strategic decisions to take. He viewed
firms as making decisions about employment, production and investment, which all affected the growth of the economy. He also disagreed with economic models where transactions happened seamlessly without lawyers, accountants or the numerous other operational aspects of real businesses.
He also argued against the anti-big-business sentiment then prevalent in America. The US was home to about half of the world’s biggest companies and yet had a strong entrepreneurial culture. Schumpeter argued that such ‘trustified’ capitalism did not stifle innovation or prevent the growth of new businesses. Alongside US multinationals, thousands of new companies emerged. Through the process of ‘creative destruction’, the most innovative survived. Schumpeter notes that from 1897 to 1904, 4,227 American companies merged into 257 large corporations, including such well-known names as Goodyear, Pepsico, Kellogg, Gillette, Monsanto, 3M and Texaco.
In Schumpeter’s view, few monopolies survived in the long term, owing to ‘creative destruction’. The successful innovator might reap monopoly profits for a while, but others in the same industry will soon try to imitate the product. The entrepreneur will preserve his profit for as long as possible through patents, further innovation and advertising, which are all acts of ‘aggression directed against actual and would-be competitors’.23 But every entrepreneur’s profit is temporary because competitors will eventually copy the innovation, causing market prices to fall. This sequence, which Schumpeter calls ‘competing down’, is observable in all industries except those protected by government. It may take several years and can be hard to see, but it is inevitable. For Schumpeter, because high profits are possible, even if temporary, big business contributes positively towards innovation and therefore economic growth.24 So why are monopolists frequently in the spotlight? In Schumpeter’s view: ‘Why then all this talk about monopoly? … Economists, government agents, journalists and politicians in this country obviously love the word because it … is sure to rouse the public’s hostility.’25
Schumpeter also believed that capitalism was a fragile system. The rise of big business undercut smaller ones who commanded greater loyalty from workers and also tended to have more political influence in their communities. In addition, society was likely to resist major innovations because they tend to destroy the status quo. He observed: ‘Entrepreneurs were not necessarily strangled’, but ‘they were not infrequently in danger of their lives’.26 For instance, craft guilds in Britain invoked medieval laws and petitioned for regulations outlawing factories and mechanical devices. In the early 1830s rural labourers smashed the new threshing machines which were threatening their livelihoods. In fact, ‘the history of capitalism is studded with violent bursts and catastrophes’.27 Schumpeter also thought that people might act against their economic interests because of their beliefs: ‘Socialist bread may well taste sweeter to them than capitalist bread simply because it is socialist bread, and it would do so even if they found mice in it.’28
Thus, Schumpeter warned: ‘I felt it my duty … to inflict upon the reader … my paradoxical conclusion: capitalism is being killed by its achievements.’29 So, political oversight was needed. Schumpeter believed that the upheaval caused by entrepreneurs could engender social turmoil which may even lead the capitalist engine to stall. Thus, economic growth required a stable government, specifically the rule of law and protection of private property. The system that he most admired was the British one with its constitutional monarchy and bicameral Parliament comprising Commons and Lords. He held in high regard Britain’s apolitical civil service, which gave that stability to a capitalist system. It is only within such a system that Schumpeter’s ‘creative destruction’ could flourish.
In Schumpeter’s system: ‘The introduction of new production methods, the opening up of new markets – indeed, the successful carrying through of new business combinations in general – all these imply risk, trial and error, the overcoming of resistance, factors lacking in the treadmill of routine.’30 These disruptions to the routine explain why economies expand and go through periods of ‘destruction’. Schumpeter argued that innovations in specific industries affected other parts of the economy, such as their suppliers, distributors and, eventually, customers. In the nineteenth and early twentieth centuries, economic growth was driven by a series of breakthroughs. Specifically, five industries led economic development: cotton textiles, railroads, steel, automobiles and electricity. Such industry-specific innovation ‘does not follow, but creates expansion’.31
Rather than an economic concept of an equilibrium that an economy returns to, Schumpeter’s view of innovation involves continuous disequilibrium that is led by entrepreneurs transforming an industry with economy-wide effects.
To enable such entrepreneurial innovators, Schumpeter stressed the importance of credit in a capitalist system. He believed capitalism to be the only system that enables people to become entrepreneurs before they have the funds to found an enterprise: ‘it is leadership rather than ownership that matters’.32 It was not only a bank credit line to keep a business operating that was necessary, but money for new ventures, which can be lost if the start-up fails without jeopardizing the entire economic system. In his career as a banker and investor, Schumpeter underwrote precisely such firms, even though it cost him his personal fortune.
That is also why he believed that the economy benefited from the rise of big business because they could afford to gamble on innovation. They also had access to capital markets, such as raising money by issuing debt on bond markets, as well as retained earnings, so were less reliant on more conservative bank loans. For instance, in the early twentieth century, firms such as American Telephone and Telegraph (AT&T), General Electric (GE), Eastman Kodak and DuPont set up research departments to develop new products. They made innovation an integral part of their business. Later in the century, large firms worldwide followed suit.
Perhaps the best examples of the Schumpeterian notion of innovation and economic growth are found in the East Asian economies, which underwent their ‘growth miracle’ during the mid-twentieth century, namely Japan, Korea, Taiwan and Singapore.33 Schumpeter even lectured to great acclaim across Japan in early 1931. He generated extensive media coverage that is hard to picture today for economic lectures. Japanese policymakers notably adopted a Schumpeterian approach. They stressed saving and investment, and actively promoted a broad range of innovation across numerous industries. A slew of new Japanese multinational companies such as Sony, Sanyo and Honda eventually became globally competitive. During that period of the 1960s to the 1980s, Japan achieved the highest sustained growth rate for a major economy and became the world’s second biggest economy. Japan’s innovative companies led the nation to such growth that Japan even threatened America’s standing.
Schumpeter’s work established the crucial role that entrepreneurs play in capitalist economies, even though entrepreneurship itself can’t be simply modelled mathematically. In his view, innovation is ‘a feat not of intellect, but of will … a special case of the social phenomenon of leadership’.34 In Schumpeter’s definition, the entrepreneur is not a business executive or even the owner or chief executive of a successful firm. He is ‘the modern type of “captain of industry” – obsessively seeking an innovative edge’.35 It can even be hard to identify the entrepreneur: ‘nobody ever is an entrepreneur all the time, and nobody can ever be only an entrepreneur’.36 Particularly in large firms, the entrepreneur often not only innovates but also carries out management. In short, Schumpeter saw entrepreneurship as a key factor to start the engine of growth: ‘Without innovation, no entrepreneurs; without entrepreneurial achievement, no capitalist returns and no capitalist propulsion.’37
For Schumpeter, ‘Capitalist evolution spells disturbance. Capitalism is essentially a process of economic change.’38 This change comes from innovative entrepreneurs. He outlined five types of innovation that derive from entrepreneurs:39
– The introduction of a new good, for example one with which consumers are not yet fami
liar, or of a new version of a good that is of better quality.
– The introduction of a new method of production.
– The opening of a new market.
– The conquest of a new source of raw materials or half-manufactured goods.
– The creation of a new organization of any industry, like the creation of a monopoly position (for example, through trustification) or the breaking up of a monopoly.
In summary, Schumpeter sees entrepreneurship as ‘essentially one and the same thing’ as technological progress that raises the growth of the economy.40
The challenge of staying on top as innovators
Nokia and BlackBerry
In the process of ‘creative destruction’, innovative products will displace old ones. In aggregate, the efforts of companies to improve the level of technological innovation hold the key to the success of the economy. The transition from old to new, though, is rarely seamless and includes the rise and fall of not just individual businesses but entire industries.