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Monday, December 03, 2007

"Creative Destruction's Reconstruction"

Brad DeLong on Schumpeter, my comments are at the end:

Creative Destruction's Reconstruction: Joseph Schumpeter Revisited, by J. Bradford Delong, Chronicle of Higher Education: My guess is that average literate Americans know of three 20th-century economists: John Maynard Keynes, Milton Friedman, and Alan Greenspan. ... In Prophet of Innovation: Joseph Schumpeter and Creative Destruction ..., Thomas K. McCraw, an emeritus professor of business history at Harvard Business School, tries to add another name to the list - Joseph Schumpeter. ...

Over the previous two and a half centuries, three different economic worldviews, in succession, reigned. In the late 18th and early 19th centuries, Adam Smith's was the key economic perspective, focusing on domestic and international trade and growth, the division of labor, the power of the market, and the minimal security of property and tolerable administration of justice that were needed to carry a country to prosperity. You could agree or you could disagree with Smith's conclusions and judgments, but his was the proper topical agenda.

The second reign was that of David Ricardo and Karl Marx. Their preoccupations dominated the late 19th and early 20th centuries. They worried most about the distribution of income and the laws of the market that made it so unequal. They were uneasy about ... whether an ungoverned market economy could produce a distribution of income - both relative and absolute - fit for a livable world. Again, you could agree or disagree with their judgments about trade, rent, capitalism, and machinery, but they asked the right questions.

The third reign was that of John Maynard Keynes. His agenda dominated the middle and late 20th century. Keynes's theories centered on what economists call Say's Law... Say's Law supposedly guaranteed something like full employment..., if the market was allowed to work. Keynes argued that Say's Law was false in theory, but that the government could, if it acted skillfully, make it true in practice. Agree or disagree with his conclusions, Keynes was in any case right to focus on the central bank and the tax-and-spend government to supplement the market's somewhat-palsied invisible hand to achieve stable and full employment.

But there ought to have been a fourth reign, for there was a set of themes not sufficiently explored. That missing reign was Schumpeter's, for he had insights into the nature of markets and growth that escaped other observers. It is in that sense that the late 20th and early 21st centuries in economics ought to have been his: He asked the right questions for our era.

He asked those questions in ... the Theory of Economic Development. Previous first-rank economists (with the partial exception of Marx) had concentrated on situations of equilibrium. ... Schumpeter pointed out that that wasn't how market economies really worked. The essence of capitalist economies was, ... the entrepreneur and the innovator: the risk taker who sets in motion new and more-efficient ways of making old or new products, and so produces an economy in constant change. ... Schumpeter saw ... that market capitalism destroys its own earlier generations. There is, he wrote, a constant "process ... 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..."

In a later book, Capitalism, Socialism, and Democracy, Schumpeter wrote that the traditional view of competition must be abandoned. "Economists," he said, "are at long last emerging from the stage in which price competition was all they saw. ... [I]n capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization - competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives." ...

The innovator shows that a product, a process, or a mode of organization can be efficient and profitable, and that elevates the entire economy. But it also destroys those organizations and people who suddenly find their technologies and routines outmoded and unprofitable. There is, Schumpeter was certain, no way of avoiding this: Capitalism cannot progress without creating short-term losers alongside its short- and long-term winners: ...

Schumpeter's ideas lay waste to economists' smooth graphs of long-run growth trends and economic evolution. Growth produces progress and wealth, but in unforeseeable ways and in discrete lumps that create many small winners (for example, the people who can now buy their shirts at Wal-Mart for $8.99 as opposed to $12.99 at its less-efficient competitors), a few huge winners (for example, the Walton family of Bentonville, Ark.), and notable substantial losers (the Main Street merchants of the Mississippi Valley, the Great Plains, and the Sun Belt).

Schumpeter ... feared for the long-term survival of capitalism. ... The challenge for the government ... becomes ... the tremendously difficult job of managing the creative destruction so that capitalism does not undermine and destroy itself for essentially political reasons. Schumpeter did not think the beast could be managed...

Capitalism ... inevitably generates ... mammoth inequalities through creative destruction. The combinations of market economies and political democracies that we see today in the richest countries in the world were, Schumpeter thought, unlikely to be stable. ... He did not think governments could maintain enough social insurance to counter the destructive part of capitalism without strangling the sources of rapid growth. ...

Schumpeter's influence was limited. He died half a decade later than Keynes, but Keynes's reputation put Schumpeter's in near-total eclipse for more than a generation. ...

McCraw is ... too devoted to his subject to see one essential strand of Schumpeter's story: the academic undervaluation that resulted from his political delusions. ... Back in 1970, the economist Harry G. Johnson pointed out that all successful founders of schools not only are geniuses with profound insights but also provide a road map that tells their followers and successors what to do to make a successful academic career within the school. Schumpeter did not do that second part.

Perhaps this next century will give Schumpeter's work its proper place as the power of innovation to transform, create, enrich, and destroy makes itself manifest globally. And while we marvel at how much he got right, we can hope Schumpeter was wrong in his political analysis. One great test of our era will be whether creative destruction can flourish alongside public order and political liberty. If not, we're in big trouble. But if so - and I'm an optimist on the point - the results could be a marvel.

I cut quite a bit out, in particular Brad's description of "how Schumpeter tripped himself up over a political understanding as clumsy as his economic understanding was brilliant," but I want to focus on something else. Many people use Schumpeter's idea of creative destruction to argue that business cycles are good. Not good in the sense of having no losers - Brad has described the winners and losers above - but good in the sense of advancing economies to higher and higher levels of growth and productivity.

Are business cycles necessary for innovation? I don't think they are - there's always an incentive to improve upon existing products or production processes, cycles are not needed for this incentive to exist. Think about a single industry. Let this industry be dynamic - due to new innovation that arrives at a constant rate, suppose that each and every year 20% of the firms fail and are replaced by new upstarts with better products or better production processes. This industry is very dynamic, undergoes rapid change, yet if the 20% replacement rate stays constant there is no cycle in this industry at all. There will, of course, be structural unemployment due to the displacement of 20% of the workforce each year, and hopefully social insurance is available to them, but the amount of structural unemployment will be constant from year to year, it won't cycle.

Thus, this industry would be very dynamic and innovative, it could even be growing as new innovations are put into place when new firms enter, but there is no business cycle here, and none is needed for the industry to grow and progress.

So, are cycles needed? I can see how they might exist in this industry, there's no reason why the rate of innovation would necessarily be constant from year to year, and the rate of innovation could have some degree of persistence over time after it moves away from its long-run trend value, but much of this variation would average out when we aggregate across industries, so the existence of industry cycles does not necessarily mean there will be cycles in aggregate activity (and the converse is also true, a stable aggregate economy does not imply there are no industry cycles). Still, there could be technological changes that are sufficiently important and widespread that they function as aggregate shocks, so technologically driven aggregate cycles are certainly a theoretical possibility.

But for the question we are asking, this has causality backwards. Yes, variations in technological innovation can produce cycles, but the question is whether cycles are needed for innovation. Hopefully the industry example above makes clear that if the rate of innovation is constant, then innovation can occur even if there are no cycles at all. So cycles are not a necessary condition for innovation - if you look at an industry and its output is growing at a constant rate over time you cannot conclude that no innovation has occurred. It's possible for old firms to be cleaned out and replaced by new ones at a fairly constant rate leading to a similarly stable rate of industry growth.

Ah, you say, but you've missed the point. We need periods of higher than average growth and periods of lower than average growth, as you get with cycles, to weed out the inefficient firms and then replace them with more efficient firms in a survival of the fittest type of process. By putting the industry under stress you are able to clear out the weaker market participants, then during the upswing when profits are high the failed firms will be replaced by new and better firms. Furthermore, and this is the important part, the rate of innovation can actually be higher with cycles than without, and you might list some journal articles making this very point.

True, cycles might provide some enhancement to innovation, but I would argue this is a second-order effect (if it exists at all) relative to the amount of innovation we would get under the constant growth scenario, and that it is not at all clear that the extra innovation and growth you get with cycles is sufficiently large to compensate for the turmoil and costs that cycles bring to with them. Until someone can prove to me that  innovation under a stable economy would be substantially depressed, an hypothesis contradicted by the high degree of innovation we have seen in the last twenty years despite the Great Moderation, I will continue to believe that we should pursue stabilization policy vigorously, i.e. that we do not need business cycles to attain high levels of employment, growth, and innovation.

    Posted by on Monday, December 3, 2007 at 01:44 PM in Economics, History of Thought, Income Distribution, Macroeconomics, Productivity, Social Insurance, Technology, Unemployment | Permalink  TrackBack (0)  Comments (35)


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