[PEN-L:3958] Schumpeter and Creative Destruction

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Note: some of the ideas in this post have been absorbed from my various
readings on the subject over time and retrieved from my folder under S.
Not being an academic economists, I apologize for not providing a
detailed bibliography and notes.  Schumpeter has been dead for 49 years,
his ideas are really in the public domain. My interest in economics is
its potential usefulness and not proprietay authorship and if any reader
feel the need to identify specific ideas to a particular economist, he
would be welcome to so so.  Again I apologize for my sloppy personal
research methodolgy.  This post represents what I understand of what
many have said; I claim no originality in economic thought.  I am a
consumer, not a producer of eocomic theory.
---- Henry C.K. Liu

Having been proven wrong by recent events on Hayekian claims on the
inherent efficiencies of free markets, neo-liberalism now drops Hayek
and parades Schumpeter and his creative destruction as the new banner of
ideology as truth.  The term has been used in recent days by Greensapan
and a whole chorus of policy makers to expain the US economy as the
remaining pocket of properity in the a world left in ruins by free
market globalization.

Schumpeter conceptualizes long waves as disturbances in the equilibrium
of an
economic system, the exhaustion of these disturbances, and an eventual
return to
equilibrium. It is this repeated return to a state of equilibrium, and
not the
repeatability of the wave form, which gives long waves their cyclical
character.
Schumpeter designates this equilibrium state as "the circular flow of
economic life" or
the "stationary flow". This state refers to a condition comparable to
simple reproduction and characterized by an absence of any change or
development. But Schumpeter is also explicit that this "stationary flow"
is only a
theoretical norm, not a real state of affairs: it serves as a reference
point from which
to define phenomena such as overproduction, excess capacity, and
unemployment.

     "These terms, as commonly used, do not carry any precise meaning at
all, and
     the fact that they do not explains the inconclusiveness of much
argument
     that goes under these headings. As soon as we find such precise
meanings
     for them and to fit them for the task of identifying definite
states of an
     economic organism, the necessity of falling back on equilibrium
relations
     becomes apparent".

In actuality, economic systems never achieve equilibrium. At best, they
move into
what Schumpeter calls "neighborhoods of equilibrium...in which the
system
approaches a state which would, if reached, fulfill equilibrium
conditions".

All economic systems have a fundamental tendency towards equilibrium
within their separate given levels of free exchange and automatically
move toward these neighborhoods after the disruptions caused by factors
of change have exhausted themselves. For his theory of long waves, the
most important characteristic of these neighborhoods of equilibrium is
that economic conditions are relatively stable and this permits what he
calls "tolerably reliable calculations" about the future. As a result,
the risks associated with engaging in new activities are at their
lowest.

In his general model, Schumpeter suggests that all cycles depart from
these
neighborhoods of equilibrium. When he introduces the notion of several
simultaneous
cycles, he relaxes the assumption that the shorter cycles begin from
equilibrium in
the strict sense of the term - "the sweep of the longer waves provides
the
neighborhood of equilibrium for the waves of the next lowest order." In
other words,
neighborhoods of equilibrium, in the strict sense, are only associated
with long waves
when "all cycles pass their normals".

Economic development is the result of many factors: external factors
such as
demand by government for new weapons and/or social justice; factors of
gradual changes in socio-economic life and "the outstanding fact in the
economic history of capitalist society" - innovation.  For Schumpeter,
innovation is the chief force in what he calls "economic evolution."
Economic evolution is however
discontinuous and takes the form of long waves because of a
discontinuity in the
introduction of major innovations into the economic system.

While the importance of innovation in Schumpeter's thought is well
known, less
attention has been paid to what Schumpeter meant by innovation.
It appears that Schumpeter's concept of innovation is both `broader' and
`narrower'
than is generally assumed by what are considered his most direct
disciples,
Neo-Schumpeterians or innovation theorists. Schumpeter's concept is
broader
because, unlike innovation theorists, he does not restrict the concept
of innovation to
the patenting or commercialization of new inventions. In addition to
these activities,
Schumpeter includes other activities such as "new combinations" in
organization,
commerce, and the market, e.g., the opening of new markets, the
discovery of new
sources of raw material and supplies, and improved handling and
transport of
materials and goods, as well as the creation of new business
organizations such as
department stores, cartels and monopolies.
The aspect is dearly embraced by neo-liberalism with regard to finance
caoitalism and globalization.

Schumpeter's concept of innovation is `narrower' because he stresses
that innovation
per se, i.e., simply as new ideas or new combinations, is not a force in
economic
development. Rather the true force in economic development is the
consequences of
these innovation: 1. ) the construction of new plants and the rebuilding
of old plants
"requiring, non-negligible time and outlay," 2) new firms which are
founded for the
purpose of capitalizing on specific innovations, and (3) the rise to
leadership of new
men (Schumpeter 1964, 68-71). These consequences make innovations a
force in
economic evolution and innovations which do not produce these
consequences, which
do not, in other words, produce other changes in the "stationary flow"
would not and
could not be a force in the economic development of a society.
Economic evolution begins when an entrepreneur of exceptional ability -
"the conductor"- introduces, in the above sense, an innovation. This
enables the individual to make monopolistic profits and stimulates the
borrowing of capital in order to increase the investment.
The activity of the first entrepreneur also smoothes the path for other
entrepreneurs
to introduce innovations in associated or related fields. This "swarming
of
entrepreneurs" is financed through credit creation, which Schumpeter
calls, "the
monetary complement of innovation." Credit permits these firms to `bid
away' factors
of production from older non-innovating firms. This produces a rise in
prices and a
general economic expansion which characterizes the first phase of
Schumpeter's four
phase model, Prosperity.
This describes globaliztion of the last 2 decades.
Prosperity peaks, i.e., reaches its upper turning point, for several
reasons. Unable to
compete with successful new firms, older non-innovating firms and
unsuccessful new
firms suffer losses. New investments are halted because the economy is
disrupted
and it becomes impossible to make reliable calculations about the
future. The
possibilities offered by the current cluster of innovations are
exhausted. Interest
rates rise. The subsequent downturn is the second phase of the cycle -
Recession.
The decline of Recession continues however, past equilibrium in a
secondary wave
which Schumpeter attributes to "errors, excess of optimism and
pessimism. ...
Reckless, fraudulent and otherwise unsuccessful enterprises created in
the optimism
of expansion cannot stand the test administered by Recession"
(Schumpeter 1964). They are liquidated. These liquidations, in turn,
undermine the debt structure
which begins to "crumble" and this causes a "panic." Deposits shrink and
credit
tightens even further. Firms which would have been able to withstand the
contraction
had it not resulted in panic are liquidated in what Schumpeter calls
`abnormal'
liquidations and among other enterprises there is "a shrinkage of
operations that
reduces them, quite erratically, below their equilibrium levels".
This is eseentially a description of the Asian financial crisis that
began in July 1997 and that since has spread its "contagion" through
Russia and Brazil, with the EU next and eventually the US.
For Schumpeter, these abnormal liquidations and the `excess' shrinkage
of
enterprises mark the third phase of the cycle - Depression.
Depression continues until all unsuccessful and excess investments are
liquidated. Once this point is reached (and it is by no means
automatic), a movement towards a new "neighborhood of equilibrium" is
initiated. This movement is the fourth phase of the cycle - Revival.
What throws Schumpeter's neat economic theory off is that before the
revival phase, soico-political instability will occur to choke of the
revival phase, as is likely to occur in SE Asian and Russia.
Schumpeter emphasizes that every cycle is "a historical individual and
not merely an
arbitrary unit created by the observer". Hence, the periodization of
long waves can only be from the neighborhood of equilibrium preceding
Prosperity to the neighborhood of equilibrium following Revival. This is
an important clue to Schumpeter's understanding of causality and stands
in marked contrast to innovation theorists who search for the `causes'
of the next prosperity in the unsettled times of depression.

For Schumpeter, long waves are formally similar but differ substantially
in their
result. Each long wave is a break with the past and the economic system
which
emerges in the Revival phase is qualitatively different from the
economic system of
the Prosperity phase of the same cycle. In other words, long waves are
not merely
passing distortions or `imperfections' in the economic system. Instead,
the
innovations which propel each long wave produce real qualitative changes
in the
economic system.

     [The] historic and irreversible changes in the way of doing things
we call
     "innovation" and we define: innovations are changes in production
functions
     which cannot be decomposed into infinitesimal steps. Add as many
mail
     coaches as you please, you can never get a railroad by so
doing...The kind of
     wave-like movement, which we call the business cycle, is incident
to
     industrial change and would be impossible in an economic world
displaying
     nothing except unchanging repetition of the productive and
consumptive
     process.

Schumpeter therefore identifies three specific long waves and their
corresponding
innovations: the Industrial Revolution Kondratieff, 1787 to 1842,
(cotton, textiles,
iron, and steam power); the Bourgeois Kondratieff, 1842 to 1897,
(railroads); and the
Neo-Mercantilist Kondratieff, 1897 to ?, (electrification, motorization,
and chemical
industries).
 In his first major work, the Theory of Economic Development, Schumpeter
wrote:

     Social facts are the result of human conduct, economic facts result
from
     economic conduct and the latter may be defined as conduct directed
towards
     the acquisition of goods ... through production and exchange. The
field of
     economic facts is first of all delimited by economic conduct.

Had he been alive now he might has added the Golbalization Kondratieff,
1971 (Bretton Wood death)-2000?

Schumpeter's emphasis on actors and conduct, as opposed to economic
facts, has
several important, yet unexplored, ramifications for his theory of long
waves.

First and foremost, innovation, for Schumpeter, is not an "economic
facts" but rather,
a type of conduct. This explains the earlier observations about both the
`breadth' and
`narrowness' of Schumpeter's concept of innovation. Its breadth is due
to the fact
that, as a type of conduct, innovation can take many forms. Innovation
is not merely
the commercial exploitation of new inventions and technology but rather
the conduct,
i.e., the forms of activity and the modalities of action, which makes
this possible.
Moreover, because innovation is first and foremost a conduct and
therefore not
necessarily tied to any specific context or field of action (such as
that defined by
technology and new inventions), this conduct can occur in almost all
arenas of social
life. Its `narrowness' is due to the fact innovation can only have an
impact on an
economic system if it engenders other, related forms of conduct such as
the
construction or modernization of new plants, or the founding of new
firms.

For Schumpeter, an adequate explanation of economic phenomena is not
simply explaining one economic fact, namely the conduct of innovation,
as the result of other economic factors. Instead, an adequate
explanation consists

     in finding a definite causal relation between two phenomena ... if
the one
     which plays the causal role is non-economic. If, on the other hand,
the
     causal factor is economic in nature, we must continue our
explanatory effort
     until we ground on the "non economic" bottom. Always we are
concerned
     with describing the general form of causal links that connect the
economic
     with the non-economic (Schumpeter).

Already it is apparent that for Schumpeter long waves can not, in the
strict sense, be
caused by the clustering of innovation - the clustering of innovation,
an economic
fact, does not represent the ""non-economic" bottom." The clustering of
innovations,
(actually, the clustering of innovative conduct) explains the dynamics
of the cycle and
its duration, but to explain this clustering it is necessary to move
even further
"backwards" into the non-economic. Hence, the `mere' clustering of
innovations is
not, in terms of Schumpeter's requirements for an adequate explanation
of economic
phenomena, the cause of the long wave.

For Schumpeter, causality must be sought at level of motives. Motives
are the
residual factor and an adequate explanation of the causes of economic
phenomena
must link economic conduct to motives. Thus, for Schumpeter, the real
cause of long waves lies at the level of what motivates the entrepreneur
to undertake his or her special and unique form of conduct, innovation.
Although entrepreneurs possesses an ability to effect this conduct and
this ability is continuously present, the conduct occurs
discontinuously. Entrepreneurs are not, in other words, always
`galvanized' to innovate. Thus, to explain what causes a clustering of
innovations it is necessary to explain what galvanizes entrepreneur to
his/her sui generis form of conduct. These factors can be accounted but
the actual individual subjective meanings underlying the innovative
activity of individual entrepreneurs, can not. In other words,
entrepreneurs may innovate for reasons of love, hate, greed, revolution,
etc., but these remain unknown. At most, links can be established
between factors which spark or galvanize the entrepreneur and the
consequences of this motivation, i.e., innovative conduct. The actual
motives are the "non-economic" bottom and once the analysis has reached
this level, causality has, for Schumpeter, been explained.

According to Schumpeter, entrepreneurs are galvanized into action under
the
following conditions: [1] the existence of new possibilities more
advantageous from the
private standpoint - a necessary condition; [2] limited access to these
possibilities
because of personal qualifications and external circumstances, and [3]
an economic
situation which allows tolerably reliable calculations. To the above, a
further condition may be added to account for the swarming of
entrepreneurs - (4) the smoothing of the way by the first entrepreneur.

Joseph Schumpeter, the Austrian economist of world acclaim, taught at
Harvard University for nearly twenty years. Born in Moravia in 1883, he
raised the specialized scope of economics to interdisciplinary,
political,
historical and social dimensions. His theories, characterized by his
open-minded approach and his desire to integrate a variety of impulses
from
different cultural milieus, scientific areas and disciplines, are even
more
relevant today, as Eastern Europe begins to experiment with capitalism.
Schumpeter recognized the vital importance of entrepreneurs in business.
He
emphasized the entrepreneur's role in stimulating investment and
innovation,
which determine the rise and ebb of prosperity. The distinction between
statics and
dynamics was essential to his account of capitalism - certain periods
approximating to equilibrium, and other exhibiting considerable change.
His analysis of business cycles started from this point and
distinguished the types and behaviour of cycles. The posthumous
History... shows a prodigious grasp of the literature of economics. In
this, as in his major book Capitalism, Socialism and Democracy, he
relates economic phenomena and ideas to a wider context of social
analysis. The latter, whilst rejecting the Marxian analysis, still
envisages capitalism as moving by its own internal forces towards
Schumpeter's vision of a socialist society.
He held a permanent faculty appointment at Harvard University in 1932.
Schumpeter's theories emphasized the role of the entrepreneur in
stimulating investment and innovation, thereby causing creative
destruction.
Creative destruction occurs when innovation makes old ideas and
technologies obsolete. Schumpeter also predicted that capitalism would
be undermined eventually by its own success because it would create a
class of intellectuals who would attack it.  Are they on this list?
Laissez faire came to be perceived as promoting monopoly rather than
competition and as contributing to boom-and-bust economic cycles, and by
the mid-20th cent. the principle of state noninterference in economic
affairs had generally been discarded. Nevertheless, laissez faire, with
its emphasis shifted from the value of competition to that of profit and
individual initiative, remains a bulwark of conservative political
thought, influential in the 1980s in such government administrations as
that of
REAGAN/THATCHER.
What is amzing and disappointing is that Clinton/Rubin/Greenspan are
also buying into it wholesale and in the process, pushing the world into
an enduring economic abyss.

Henry C.K. Liu












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WITH THE DISMEMBERMENT of
                    the Soviet empire, the retreat of
                    socialism and the spread of global
                    capitalism, Karl Marx is out.
                    Joseph Schumpeter, so often
                    praised in Forbes but for long
                    ignored by the rest of the media,
                    is now in. Published in the year
                    of Schumpeter's death (1950), his
                    Capitalism, Socialism and
                    Democracy unfolds like a play.

                    Act I describes and extols the
                    dynamism of capitalism. "Unlike
                    other economic systems, the
                    capitalist system is geared to
                    incessant change...," he wrote.
                    "This process of Creative
                    Destruction is the essential fact
                    about capitalism." It keeps the
                    system healthy by weeding out
                    the weak businesses, nourishing
                    the strong ones and thereby
                    raising living standards by
                    promoting efficiency and
                    innovation. The capitalist society
                    Schumpeter projects is not a
                    comfortable or easy place, but it
                    is the best means for lifting the
                    masses of the people out of
                    poverty.

                    In Act II, Schumpeter introduces
                    portents of tragedy when he
                    argues that capitalism's success
                    sows the seeds of its own
                    destruction. Societies become so
                    rich that they can support a
                    growing class of chatterers who,
                    feeling slighted by the success of
                    the entrepreneur and dismayed
                    by the growing satisfaction of the
                    masses, seek to undermine the
                    system. What the entrepreneur
                    creates, Schumpeter warns,
                    left-leaning intellectuals can
                    destroy.

                    In Western Europe, alas,
                    Schumpeter's Act II seems to be
                    unfolding on schedule. The
                    chatterers, their message
                    reinforced by the inevitable
                    turmoil caused by Schumpeter's
                    "creative destruction," are having
                    their way. France, a country that
                    has resisted capitalism and
                    embraced the welfare state more
                    aggressively than most other
                    European countries, has
                    stagnated since the mid-1970s.
                    The portion of the working-age
                    population that is employed has
                    dropped from 65% to 59%. And
                    the private sector's share of total
                    employment has steadily
                    withered from 56% in the
                    mid-1970s to only 49% today. In
                    consequence, France is on the
                    brink of bankruptcy and
                    international irrelevance. The
                    other welfare states of Western
                    Europe aren't far behind.



                         President Chirac and
                         Chancellor Kohl
                         refused to be fitted out
                         with jeans, cowboy hats
                         and boots.



                    If his fellow liberals in Europe
                    haven't gotten the message,
                    however, the ever opportunistic
                    Bill Clinton has. At the June G-7
                    Summit in Denver, Clinton said,
                    "America's economy is the
                    healthiest in a generation and
                    the strongest in the world." His
                    aides passed out charts depicting
                    vigorous U.S. growth and job
                    creation, compared with the
                    dismal performances in Europe.
                    This did not go down well.
                    President Chirac and Chancellor
                    Kohl refused to be fitted out with
                    jeans, cowboy hats and boots for
                    one of the Denver banquets.
                    They were damned if they were
                    going to be seeming to endorse
                    America's "Wild West" capitalism.
                    If the rest of the world is moving
                    toward capitalism, they want to
                    stop the world so they can get
                    off.

                    Lest we become complacent
                    about the final triumph of
                    capitalism, we should pay
                    attention to Western Europe's
                    stubborn resistance to
                    Schumpeterian doctrine. The
                    summer 1997 issue of the
                    respected journal Foreign Policy
                    contained a piece titled "The
                    Crash of Civilization: the Limits of
                    the Market and Democracy." It
                    was penned by none other than
                    Jacques Attali, the Pico della
                    Mirandola of French intellectuals
                    and celebrated adviser to French
                    politicos.

                    Attali waxed eloquent about the
                    alleged dark side of capitalism.
                    What Schumpeter calls creative
                    destruction, Attali calls
                    dehumanizing.Listen to this:
                    Unless the U.S. "begins to
                    recognize the shortcomings of the
                    market economy and democracy,
                    Western Civilization will gradually
                    disintegrate and eventually
                    self-destruct." Right here in the
                    U.S., George Soros, that
                    speculator with intellectual
                    pretensions, has been uttering a
                    similar message.

                    Some of this Attali-Soros
                    chattering can be chalked up to
                    old-fashioned America-bashing.
                    But be careful: Joseph
                    Schumpeter predicted that the
                    anticapitalist chattering
                    classes?who, let us not forget,
                    dominate the media?would bring
                    the system down, despite its very
                    obvious successes. He might yet
                    be right?at least in Western
                    Europe.
This process is what
     the famous economic historian Joseph Schumpeter called
     the "creative destruction" that characterizes a
     market-driven, capitalist economic system. Like everyone
     else in the technology area, I have always been on the
     lookout for the next new innovation that would fuel the
     growth of the company that could bring it to market. What I
     didn't appreciate, until I stumbled across this thread and
     followed the comments for several months, is that the flip
     side of most long opportunities was the opportunity to
     short--Schumpeter's creative destruction at work. This is
     obviously old hat to traders--witness Roger's comment that
     he didn't care whether the market went up or down, so
     long as he could continue to trade. But to an economist,
     watching--and participating--in creative destruction
     provides new insights into the functioning of markets
     generally. Many thanks to all for the thread!

Capitalism's creative ability, Schumpeter argued, is only half of its
success story. Just
as capitalism builds up new modes of production, so too does it perform
the less
popular but equally necessary task of eliminating and disbanding
obsolete industries.
Schumpeter termed this the "creative destruction" of the free market:

The opening up of new markets, foreign or domestic, and the
organizational
development from the craft shop and factory to such concerns as U.S.
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.

Schumpeter therefore has a compelling explanation for why economic
progress under
capitalism has been so dramatic. Most historical economic systems, from
feudalism to
mercantilism to socialism, cement economic power in the hands of a
self-satisfied
orthodoxy. Statist economies deliberately shield producers from change;
the surest
path to success is to gain the favor of the government, rather than the
favor of a
clientele. In contrast, laissez-faire capitalism strips established
interests of
governmental protection, and throws the economic contest wide open.
While this
theoretical ideal has never been fully implemented, the facts strongly
support
Schumpeter's interpretation; in relatively unregulated economies,
industry leaders
frequently lose their dominance while competitors forge ahead. Thus,
after Henry
Ford virtually created the modern automobile industry, he was displaced
by General
Motors; some years later, American auto-makers desperately sought
governmental
protection from Japanese competitors that suddenly threatened their
entrenched
position. While other firms hold their lead, the danger of falling
behind remains real:
Microsoft retains its leading position in computer software, but the
company must
struggle merely to avoid falling behind.

"creative destruction" refers to the way that economic advances make
     existeng economic capital ideas absolescent: thay are partially
destroyed (in
     value term). Existing models have only considered how additions to
economic
     knowledge make existing knowledge less valuable. This paper
recognises
     that both knowledge and capital obsolesce and considers the effect
on both.

By that definition, socialism will apply creative destruction to
capitalism.