by Linda Yueh
The correlation between the emergence of innovative companies and the growth prospects of their home countries fits Schumpeter’s view of how innovation fuels the engine of economies. As a case study, China’s experience exemplifies how even a fast-growing economy faces obstacles. For countries that do not benefit from Chinese growth rates, the challenge is even bigger.
Motivated to the end
What would Joseph Schumpeter think about how contemporary companies and countries should innovate?
Schumpeter’s legacy is to show that capitalism depends on entrepreneurs who in turn require a supportive system. He rejected the simple assumptions made by economists about how producers and consumers operate.42 He believed that what was needed was empirical analysis of actual businesses, such as the ones discussed earlier, to understand the innovative activities of entrepreneurs. With that understanding, we can then assess what propels the engine of economic growth.
The above companies largely rose and fell through competition over the past several decades. It’s become evident that, in this digital era, start-up costs have dropped sharply, so in that sense entrepreneurship has become easier than before. The internet allows a business to be set up at virtually zero cost, which makes self-employment, particularly in the services sector, simpler and cheaper. Therefore, so long as countries were supportive of entrepreneurs in terms of providing a stable system with sources of funds for investment, Schumpeter would not see innovating in the services sector as harder than in manufacturing. So, in predominantly services economies like Britain, America and much of western Europe, Schumpeter would not view entrepreneurship as more challenging than when he witnessed the emergence of manufacturing powerhouses, which had much higher start-up costs, and yet succeeded.
As Schumpeter foresaw, innovative companies have helped to lead their home countries’ economic growth. Apple’s and Google’s dominance mirrors America’s reign at the top of the global economy. The challenger China’s encroachment is reflected in the rise of its start-ups that are snapping at the established tech giants’ positions. Unlike state-owned companies, a number of Chinese multinational firms, such as Alibaba and Huawei, have been founded by entrepreneurs. Such entrepreneurial innovators are those whom Schumpeter had in mind when he described companies shaping the growth of economies. So long as China continues to produce innovative companies, then he would expect the world’s second biggest economy to transform itself into an innovative economy and ‘Made in China’ to be seen as a marker of quality.
Whether it’s America or China or Japan, entrepreneurs will determine the growth potential of the country, in Schumpeter’s view. As described in Capitalism, entrepreneurial innovation is the dynamic element that drives how economies evolve through a process of ‘creative destruction’, which is as visible today as during his time.
But, due to the economy experiencing constant innovation and obsolescence as a result of entrepreneurship, the inventor of ‘creative destruction’ would be reluctant to predict how a capitalist system might evolve. Schumpeter would be unlikely to be found on a stage at a conference predicting the next technology to disrupt an established market!
He had ample opportunities to do so. By his mid-sixties, Joseph Schumpeter was one of the most famous economists in the world. There was no Nobel Prize in economics during his lifetime, but he was hugely acclaimed.
Schumpeter was elected as president of the American Economic Association in 1947, the most prestigious office in the country for an economist and one of the very few occasions in its history that a foreign-born economist had been chosen. In 1949 he was also selected as president of the new 5,300-member International Economic Association headquartered in Paris.
Acclaim only fuelled his work ambitions. During 1949 and the early part of 1950 he wrote twelve articles, the most in any comparable period since the 1920s. He died of a cerebral haemorrhage one month before his sixty-seventh birthday at the height of his fame. His final book, History of Economic Analysis, was published posthumously in 1954.
Motivated to the end, Schumpeter was similar to those he wrote about. He didn’t believe that entrepreneurs, or indeed consumers, would ever be satisfied. He placed himself, with his penchant for reinvention during a varied career, among the ranks of those innovators, many of whom have changed the way that we live. Schumpeter believed that the innovator-entrepreneur had a ‘will to conquer … Our type seeks out difficulties, changes in order to change, delights in ventures.’43
CHAPTER 8
Friedrich Hayek: What Can We Learn from Financial Crises?
On 15 October 2011 members of the Occupy movement attempted to set up a protest camp in Paternoster Square, outside the London Stock Exchange. They were foiled, as the area was privately owned, so any protesters would have been trespassing and the police were able to seal off the entrance before any could enter. However, the group of around 3,000 people simply gathered instead outside nearby St Paul’s Cathedral, where an indefinite camp was established. A month earlier a similar encampment had been set up in New York’s Wall Street, and soon protests of different sizes emerged in cities around the world.
Occupy’s slogan, ‘We are the 99 per cent’, referred to the high proportion of global wealth accounted for by the top 1 per cent of the distribution. They reflected the widespread public anger in the aftermath of the 2008 global financial crisis. The protesters called for financial reform, a fairer distribution of income and wealth and a rejection of austerity.
The Occupy movement reflected the modern version of a struggle that had been ongoing since the previous century. The twentieth century had witnessed an ideological battle between socialism and welfare state capitalism, culminating in the triumph of the latter with the fall of the Berlin Wall and the lifting of the Iron Curtain in 1989, which led to the break-up of the Soviet Union in 1991. Economics Nobel laureate Milton Friedman had observed:
There is no figure who had more of an influence on the intellectuals behind the Iron Curtain than Friedrich Hayek. His books were translated and published by the underground and black market editions, read widely, and undoubtedly influenced the climate of opinion that ultimately brought about the collapse of the Soviet Union.1
In the aftermath of the global financial crisis, the future of capitalism was once again up for debate. Had he been alive, free-market proponent Friedrich Hayek would have challenged the view that capitalism’s time was up. He believed that the prosperity of society was driven by creativity, entrepreneurship and innovation, which were possible only in a society with free markets.
Hayek was a leading voice of the Austrian School. In the 1940s he disavowed the Keynesian revolution that was sweeping through the economics establishment. He attacked socialism when the welfare state was being formed in most major economies. In Hayek’s view, socialism would invariably lead to central planning. When it comes to technological development, no progress can be made unless people are allowed to move into unexpected areas and learn from their mistakes. In The Road to Serfdom, Hayek describes how totalitarian regimes are not just unproductive but also suppress these freedoms. (The title of his best-known book comes from a phrase used by the French writer Alexis de Tocqueville, ‘the road to servitude’.2) Instead, markets create the price signals and incentives to orientate the economy most efficiently.
To the wrath of the Occupy protesters, he would also have been less concerned about inequality, as he strongly believed societal progress was driven by the ideas of a few. When it came to financial markets, he would have said that they were already overregulated instead of not regulated enough. There is no doubt that Hayek would have been a controversial figure in the post-crisis world. Certainly, having spent most of the twentieth century fighting socialism, he would have much to say on the future of capitalism in the twenty-first.
The life and times of Friedrich Hayek
Friedrich August von Hayek was born in 1899 in Vienna. His father was a doctor employed by the Municipal Ministry of Health, and his m
other came from a wealthy landowning family.
From a young age, Friedrich, or Fritz, as his mother called him, was determined to become a scholar. His father’s true passion was botany and he had become a part-time lecturer at the University of Vienna, but above all wanted to become a university professor. This rubbed off on the young Friedrich. He helped his father with his botanical collections and came to believe that professorship was the highest accolade.
Despite this, and unlike many of the Great Economists featured in this book, he was not a first-class pupil. In fact, he showed little interest in studying at school and was actually rather rebellious. At the age of fourteen he failed Latin, Greek and mathematics and had to repeat the grade. Even so, he was still considered bright.
By the time Hayek turned fifteen, his attention was captured by the political excitement stoked up by the events that would lead to the First World War and the collapse of the Austro-Hungarian Empire. His focus turned to political philosophy, including ethics, morals, politics and economics.
Two years later, in March 1917, with the war still continuing, Hayek joined the army. He was still two months short of his eighteenth birthday, and after seven months of training was sent as an officer to the Italian front. He nearly did not survive the war. A piece of his skull was stripped by shrapnel. He nearly died when jumping from an observation balloon without first detaching his headphones, and he was nearly shot down in a dog fight. He had decided he wanted to join the diplomatic service, but before doing so he ended up joining the air force to prove he was not a coward.
However, the war was to end sooner than Hayek expected. In late 1918 he returned from Italy and enrolled at the University of Vienna. He studied law, but became interested in psychology, and eventually chose to become an economist: ‘I was about equally interested in economics and psychology. I finally had to choose between the things I was interested in. Economics at least had a formal legitimation by a degree, while in psychology you had nothing. And since there was no opportunity for a job, I decided for economics.’3
Economics was part of the law faculty and offered, Hayek believed, the best vocational and financial prospects.
Life in Vienna, the capital city of the new Republic of Austria, was tough immediately after the war. Over a million young men from the Austro-Hungarian Empire had perished in the fighting. There were chronic shortages of food and fuel. Hyperinflation, or dramatic price increases, plagued the economy.
As with much of Europe, the conditions were ripe for communism and socialism to take over. There was a sudden acceptance and respect for Marxism, the welfare state and the planned economy. Hayek, though, was never enamoured of Marxism. He considered it very doctrinaire, and although reform and revolution were the sentiment of the day, he did not believe socialism to be the answer.
Economics at the University of Vienna was firmly established in the liberal free-market tradition, where Carl Menger was the architect of what came to be known as the Austrian School of economics. This school of thought contrasted with the collectivism of Marxism sweeping through much of Europe, emphasizing the importance of individuals and their free actions. Menger had described the concept of spontaneous order, wherein it is possible for a peaceful society to arise simply as a result of the rule of law creating the societal structure in which people flourish. The role of government then is not to direct the economy, but to establish and enforce the laws of property and those governing exchange that enable individuals to interact with each other in a mutually beneficial way. Liberty is a reflection of the supremacy of law, not its absence. Spontaneous order would be the centrepiece of much of Hayek’s later thinking.
In 1921 he started working in the Austrian Office of Accounts (set up to settle international debt claims) for the economist Ludwig von Mises, who was well known as a monetary theorist and part of the Austrian School of economic thought at the University of Vienna. A couple of years later Hayek moved to New York in order to broaden his economics training. While he was working as a research assistant at New York University, his fellow Austrian Joseph Schumpeter wrote letters of introduction for him to meet a range of American economists.4 It was there that he started work on a theory of business cycles. He also began, but did not complete, a doctoral thesis. The post-war hyperinflation in Austria had destroyed his family’s wealth and he could not afford to live in any way other than poorly. After only one year, he returned to Austria.
Hayek was back in Vienna in 1924, once again in the Office of Accounts. But his marriage to Hella Fritsch soon thereafter led him to seek a more permanent job. Hayek had been close friends with von Mises, who helped to establish the Austrian Institute for Business Cycle Research based in Vienna, and in 1927 Hayek became its director. Initially, he had just two clerical assistants. It was later funded more generously by the Rockefeller Foundation. Hayek wrote prolifically during this period. His brief tour of the US led him to realize how new economic and statistical techniques could be introduced into economic research.
In the late 1920s Hayek wrote a number of articles in which he began to articulate business cycle theory. He opposed the US central banking system, the Federal Reserve, which had been set up in 1913. Hayek disapproved of the Fed’s role in economic ups and downs.
It was not just monetary policy. Hayek also disputed the use of fiscal policy in moderating business cycles. His work was an early attack on John Maynard Keynes’s hypothesis of excess saving or the paradox of thrift, discussed in Chapter 6. One of these articles, the ‘Paradox of Saving’, published in 1929, had caught the attention of Lionel Robbins, a young economist who had been recently appointed head of the Economics Department at the London School of Economics and Political Science (LSE). Hayek was the same age as Robbins.
Robbins wanted to bring British economics more fully into the twentieth century, so he sought a qualified theorist and one who was familiar with the other traditions. He sought to make the LSE a leading institution in the internationalization of British economics, and also to help him in his argument with Cambridge’s John Maynard Keynes. In particular, Robbins opposed Keynes’s ideas of increased spending on public works to battle the Great Depression. Robbins and Keynes had repeatedly clashed, and Robbins saw Hayek as an ally. So, Hayek arrived at the LSE in 1931 to deliver a series of four lectures, after which he was invited to join the faculty.
Hayek versus Keynes
It is fair to say that watching economics videos is not always the most exciting pastime. However, it is worth viewing Fear the Boom and Bust, launched on YouTube in 2010, where two proxies of Hayek and Keynes engage in a rap battle. Their argument is over the cause of the business cycle, and so far it has been viewed in excess of 6 million times. A sequel, where the two characters proclaim their responses to the Great Recession, is also available to watch should the mood take you. Their debate, although focused on the Great Depression of the 1930s, has been resuscitated by the recent global financial crisis. There is all of a sudden new interest in what Keynes and Hayek have to say about booms and busts.
Hayek was seen by many as Robbins’s bulwark against Keynesian domination of economics and policy. It was not just Hayek versus Keynes, but also the LSE versus Cambridge. Despite this, the relationship between Hayek and Keynes was mutually respectful, even though they disagreed on most things and were rather being pitted against each other. In fact, Hayek and Keynes grew closer during the Second World War. Hayek became a British citizen in 1938, but his Austrian birth prevented him from serving in the war. When the London School of Economics relocated to Cambridge to avoid the Luftwaffe’s Blitz on London, it was Keynes who had arranged rooms at his college, King’s, to serve as Hayek’s base.5 The two purported rivals even spent a night together on the roof of the college chapel on the watch for German bombers.6 In 1944 Keynes nominated Hayek to become a fellow of the prestigious British Academy instead of his disciple, Joan Robinson.7 Upon Keynes’s death in 1946, Hayek wrote to his widow that Keynes was ‘the one really great man I ever
knew, and for whom I had unbounded admiration’.8 In contrast, Hayek never spoke with such personal admiration about Milton Friedman, even though they were both strongly connected with the Chicago School brand of liberalism in the 1950s and 1960s.
Hayek had been an early fan of Keynes, especially for his outspoken views on the Treaty of Versailles wherein he criticized the huge reparations demanded of Germany because he believed they would lead only to default. Keynes’s 1923 A Tract on Monetary Reform was even lauded by Hayek. Keynes was also very generous in return. In the 1920s, Keynes was an influential economist, well known and highly regarded around the world, while Hayek was young, not a native English speaker, and far from established. Yet Keynes had responded graciously to Hayek’s letters – so graciously that Hayek probably overestimated Keynes’s professional opinion of him.
Perhaps at Robbins’s behest, given the LSE–Cambridge rivalry, Hayek would later frequently criticize Keynes. In his review of Keynes’s 1931 A Treatise on Money he had been very critical, even though Keynes had positively acknowledged the emerging German and Austrian Schools. But Keynes replied in kind. He was terribly rude about Hayek’s Prices and Production of the same year, describing it as: ‘one of the most frightful muddles I have ever read … It is an extraordinary example of how, starting with a mistake, a remorseless logician can end up in Bedlam.’9 Throughout his life, and after Keynes’s death, Hayek would give interviews in which he questioned Keynes’s understanding of the most basic economic concepts. He tended to get annoyed by what he regarded as the inconsistencies in Keynes’s work and his propensity to change his position on economic issues.