The Night Watchman

The only authorized source of the thoughts and opinions of Per-Olof Samuelsson


Stray Observations on Joseph A. Schumpeter

Marx was wrong in his diagnosis of the manner in which capitalist society would break down;
he was not wrong in his prediction that it would break down eventually.
(Capitalism, Socialism and Democracy, p. 424f.)

Some years ago I bought Joseph Schumpeter’s Capitalism, Socialism and Democracy in a second hand bookstore and then forgot to read it until recently. (I also bought his Great Economists in a Swedish translation.) Then a well-known Objectivist – Raymond C. Niles – wrote about Schumpeter on Facebook: he though that Schumpeter’s business cycle theories and his views on the role on the entrepreneur might be superior to the "Austrian" view on those subjects (although, in all fairness, he had not quite made up his own mind.) I engaged in some debate with him, but after a while I lost patience and backed out of the debate (basically, I wanted to make up my own mind without his interference).

Anyway, I read the book, and I also borrowed from the library a collection of essays by Schumpeter in a Swedish translation. (I also read part of Great Economists.) I also posted some notes on Schumpeter on Facebook; most of the material here is a compilation of those notes.

As the titles says, you should take the following as "stray observations". Maybe, some day, I will be able to write a better integrated analysis and criticism.

I had originally planned a more provocative title: "Joseph Schumpeter – Friend or Foe of Capitalism?". As far as I can make out, Schumpeter did prefer capitalism to socialism, and it was "with a heavy heart" that he predicted that socialism would ultimately prevail. (In fact – as I have learned from reading a biographical sketch – Schumpeter hated socialism and communism.) Also, it should be noted that Schumpeter was extremely circumspect: He did not mean to say that socialism is inevitable, just that there are strong tendencies pointing in this direction. And looking at the world, it is hard to disagree with him on this point. We do live in a mixed economy, and what will be the ultimate outcome of the struggle between the two parts of the mixture we cannot know for sure; all we can do is to work in the right direction – spread the right ideas and hope for the best.

"Creative destruction" or "destructive creation"?

To most people, Schumpeter is best known for having coined the phrase "creative destruction" and the idea that capitalism is a process of "creative destruction". He refers to the fact that older technologies are continually being replaced by newer and better technologies – a standard example being that the horse-and-buggy has been replaced by the automobile. There are of course numerous examples of this. To give you one simple example (that Schumpeter himself couldn’t have thought of):

Not too many decades ago, many of us possessed a typewriter or used a typewriter on the job. The typewriter industry was a successful industry; there was always a demand for more and/or better typewriters. And improvements were made: we went from manual typewriters to electrical typewriters. Today, virtually nobody uses a typewriter; its role has been taking over by word processors. And, as a result, there are no longer companies specializing in manufacturing typewriters. This particular branch of industry has been wiped out.

There are of course many more examples that you can think of yourselves. A similar phenomenon is that people do not write letters the way they did before; they use e-mail instead. And so on.

Now, this phenomenon was certainly not an original discovery made by Joseph Schumpeter. He merely coined a phrase for it – a phrase which is obviously an oxymoron: how could "destruction" be "creative"? If we take this phrase seriously, we might as well coin the opposite phrase, "destructive creation". Nevertheless, this idea that creation is destructive or that destruction is creative, seems to lie at the center of Schumpeter’s analysis of capitalism.

Schumpeter vs. Mises

As you probably know, Schumpeter is not regarded as a member of the "Austrian" school, although he was born in Austria and although, in his youth, he studied under Eugen von Böhm-Bawerk. I may write more extensively on Schumpeter in the future (time permitting); here I just want to focus on a couple of points where he obviously (and flagrantly) deviates from Mises. The quotes are obviously taken out of their full context, but I think they are illuminating all the same.

Schumpeter, in his book, asks two fundamental questions: "Can capitalism survive?" and "Can socialism work?" He answers both those questions in the affirmative. He does believe that capitalism will ultimately be replaced by some form of socialism – he just isn’t 100% sure about it. He also believes that socialism, once the transition from capitalism has taken place, could actually work (although he is not 100% sure about that, either.) If this sounds confusing – well, it is confusing. (Or, at the very least, it makes me confused.)

The two points I would like to take up is his view (versus Mises) on fiduciary media and his view (versus Mises) on the so-called calculation problem in a socialist economy. (I presuppose some familiarity on my readers’ part with The Theory of Money and Credit and Socialism: An Economic and Sociological Analysis.)

On the first of these subject, Schumpeter makes a distinction between what he calls "commercial society" and capitalism – he takes the latter as a sub-division of the former. In his own words:

Commercial society is defined by an institutional pattern of which we need only mention two elements: private property in means of production and regulation of the productive process by private competition (or management or initiative). Such a type of society is not as a rule purely bourgeois […] Nor is commercial society identical with capitalist society. The latter, a special case of the former, is defined by the additional phenomenon of credit creation – by the practice, responsible for so many outstanding features of modern economic life, of financing enterprise by bank credit, i.e. by money (notes or deposits) manufactured for that purpose. (P. 157; emphasis added.)

The "credit creation" he talks about here is not what Mises would call "Sachkredit", i.e. credit consisting of actual "commodity money" (gold and/or silver). It is clearly "circulation credit", i.e., credit created through the issuance of fiduciary media: it is money manufactured for that very purpose.

This means that, on Schumpeter’s view, fiduciary media is not something that disturbs the working of a capitalist economy – on the contrary, it is the very basis of capitalist society (it is what basically distinguishes capitalist society from a merely "commercial" society).

The "Austrian" (or "Misesian") understanding of fiduciary media is that it is a bad thing even under free banking and a total disaster when it is added to the fiat or paper money that we have today: it sets the business cycle in motion and will ultimately lead, either to a deep depression (the deeper, the longer it is postponed) – or to hyperinflation, which is even worse, since it effectively destroys the value of money. (Schumpeter, by the way, has his own theory of business cycles; it is refuted by Murray Rothbard in America’s Great Depression, p. 69ff.)

If Schumpeter is right, then capitalism is not destroyed by fiduciary media or credit expansion (over and above credit given in the form of "commodity money") – it is destroyed by the absence of fiduciary media and artificial credit expansion.

Enough about this for now. The second point is the "calculation problem" in socialism. On this he writes:

There is nothing wrong with the pure logic of socialism. […] The only authority standing for denial [of this point] that we need to mention is Professor L. von Mises. Starting from the proposition that rational economic behavior presupposes rational cost calculation, hence prices of cost factors, hence markets which price them, he concluded that in a socialist society, since there would be no such markets, the beacon lights of rational production would be absent so that the system would have to function in a haphazard manner if at all. (P. 172.)

Although this presentation is very condensed, I think it is a fair summary of Mises’ view. But does Schumpeter accept it? No. He spends page after page trying to show that the calculation problem indeed can be solved by socialism. Unfortunately, his reasoning is so contorted that I cannot make heads or tails of it. I have to dismiss it with a sarcasm: he is presenting something he calls a "blueprint" of socialist society – but this blueprint is nothing but a blueprint of a castle in the air.

Schumpeter’s business cycle theory

As for Schumpeter’s business cycle theory (which some people seem to regard as a serious competitor to the "Austrian" theory), I would say that it is not about business cycles at all. Using Rothbard’s terminology (from America’s Great depression), it may explain business fluctuations, but not business cycles. It seems that Schumpeter was not even aware of the "Austrian" (or "Misesian") theory. He was certainly not aware of the crucial role played by what Mises calls "circulation credit" in inaugurating the business cycle. Nor of the closely related role played by fiduciary media.

So what is his business cycle theory? In short, and of course rather simplified: There comes a new innovation, creating a new branch of industry; capital is gravitating to this new branch; investments are made in this branch; credit is granted to it. But the innovation does not stay new for long; it may in its turn be replaced by some other innovation; or the development simply stagnates. The investment and credit dries out (Schumpeter calls this "vanishing investment opportunities").

Concrete examples of this are: the invention of the steam engine in the beginning of the industrial revolution; the building of railways in the 19th century; the advent of the automobile in the early 20th century; and, of course, today the computer revolution. (This is of course just a short list of examples that could easily be multiplied.)

It is undeniable that those innovations have vast effects on the economy. But do they explain the business cycle? No. They explain why capital gravitates to, and then away from, specific branches of industry. This is what Rothbard calls business fluctuations. (And this is also something George Reisman writes extensively about in Capitalism, although he does not use this term.) But a business cycle is economy-wide; it affects every branch of business. And it can only be explained the way Mises and other "Austrians" explain it; as a result of inflationary policies and artificial credit expansion. (By "artificial" I mean credit financed by new paper money and/or fiduciary media. I have to add that, because when I discussed this on Facebook, someone asked me what I meant by "artificial".)

* * *

Here is a quote that I think illustrates the difference between Schumpeter and the "Austrians":

He [Karl Marx] aptly says that "the superficiality of Political Economy shows itself in the fact that it looks upon expansion and contraction of credit, which is a mere symptom of the periodic changes of the industrial cycles, as their cause." (Capitalism, Socialism and Democracy, p. 40; emphasis added.)

According to the "Austrians", expansion and contraction of credit is a phenomenon that lies at the very core of the business cycle. Marx says it is the other way ‘round: they are a "mere symptom"; And Schumpeter agrees.

* * *

Has Schumpeter anything in common with Mises? Yes – but on an issue where Mises is clearly wrong! He shares the idea that ultimate ends are outside the realm of reason.

Schumpeter on inflation

Schumpeter has a couple of interesting paragraphs on socialism and inflation; before I quote them, I will try to set the context:

Schumpeter believes, with Marx, that capitalism will lead to socialism "in the fullness of time". He considers two cases: the first is that capitalism has "matured"; i.e. has led to monopolies. In that case, the transition to socialism would be fairly painless. But if you try to instigate socialism before capitalism has "matured", there will be some transitional problem to be solved. (This is of course a very short summary.) Now to the quote:

The first thing which must be done is to bring about inflation. The banks must be seized and combined or coordinated with the treasury, and the board or ministry must create deposits and banknotes using traditional methods as much as possible. I believe inflation to be unavoidable because I have still to meet the socialist who denies that in the case under discussion the socialist revolution would at least temporarily paralyze the economic process or that in consequence the treasury and the financial centers would for the moment be short of ready means. The socialist system of bookkeeping and income units not being as yet in working order, nothing except a policy analogous to that of Germany during and after the First World War or that of France during and after the revolution of 1789, notwithstanding the fact that in those cases it was precisely the unwillingness to break with the system of private property and with the methods of commercial society that enforced inflation for so considerable a time; for "the day after the socialist revolution" when nothing would be in shape, this difference does not matter.

It should be added however that besides necessity there is another motive to embark upon this course. Inflation is in itself an excellent means of smoothing certain transitional difficulties and of effecting partial expropriation. As regards the first, it is for instance evident that a drastic increase in money wage rates will for a time avail to ward off possible outbreaks of rage at the fall in real wage rates that, temporarily at least, would have to be imposed. As regards the second, inflation expropriates the holder of claims in terms of money in a delightfully simple way. [Yes: delightfully.] The board might even make matters easier for itself by paying owners of real capital – factories and so on – any amount of indemnities if it resolves at the same time that these shall become valueless before long. Finally, it must not be forgotten that inflation would powerfully ram such blocks of private business as may have to be left standing for the moment. For, as Lenin has pointed out, nothing disorganizes like inflation: "in order to destroy bourgeois society you must debauch its money." (Capitalism, Socialism and Democracy, p. 226f.)

Now, this is really a strong indictment, both of inflation and of socialism. But it does not seem that Schumpeter himself saw it that way. (If he did, why wouldn’t he fight socialism the way Mises did?) – Someone has told me that Schumpeter writes in an "ironic" style. But I don’t think this is irony; it is sheer cynicism.

Schumpeter on the gold standard

I found this on Wikipedia (it is from a book called History of Economic Analysis):

An "automatic" gold currency is part and parcel of a laissez-faire and free-trade economy. It links every nation’s money rates and price levels with the money-rates and price levels of all the other nations that are "on gold." It is extremely sensitive to government expenditure and even to attitudes or policies that do not involve expenditure directly, for example, to foreign policy, to certain policies of taxation, and, in general, to precisely all those policies that violate the principles of [classical] liberalism. This is the reason why gold is so unpopular now and also why it was so popular in a bourgeois era. It imposes restrictions upon governments or bureaucracies that are much more powerful than is parliamentary criticism. It is both the badge and the guarantee of bourgeois freedom—of freedom not simply of the bourgeois interest, but of freedom in the bourgeois sense. From this standpoint a man may quite rationally fight for it, even if fully convinced of the validity of all that has ever been urged against it on economic grounds. From the standpoint of etatisme and planning, a man may not less rationally condemn it, even if fully convinced of the validity of all that has ever been urged for it on economic grounds.

He is right, of course. Gold is part and parcel of a laissez-faire society. Socialists must be against it.

Schumpeter on the role of the entrepreneur

Apart from "creative destruction", Schumpeter is most famous for his analysis of the role of the entrepreneur in a capitalist society. To quote my adversary Raymond Niles:

For a student of economics, as I am, the most notable thing about him is his nearly heroic assessment of the importance of the entrepreneur. His biggest contribution to economics is that he places the creative entrepreneur at the center of capitalism, and as the spark plug of material progress. Then he explains the economic consequences, the mechanism, of how that entrepreneur's actions create a rising standard of living. No other economist, to my knowledge, does this. (Ayn Rand does this, but as a philosopher.)

From what I have read so far, I think this is true. He has observations of the role (and psychology) of the entrepreneur that I have not encountered elsewhere. (See his essay "Change and the entrepreneur" from 1949, which I have read in a Swedish translation.)

It is of course not true that my own favorite economists (such as Mises and Reisman) have had nothing to say about the entrepreneur. But Schumpeter does add to our knowledge here.

But I should also say that this, however true it might be, has no bearing on the issue of what causes business cycles.

Schumpeter on democracy

Schumpeter also has an interesting theory of democracy, but it is deceptively simple: he rejects the idea that democracy is an expression of "the will of the people" (in all its variants) and says it is "competition for political leadership". (I generally agree with his analysis – but he does not go into the really important question: what are the proper limits of government?)

Is Schumpeter of value to an Objectivist?

Since the person who triggered my interest in Schumpeter is an Objectivist, I ask myself if there is anything in Schumpeter to be "gained and/or kept" by Objectivists.

Well, Objectivism holds that the mixed economy in which we live today is a mixture of freedom and controls – or, to put it another way, that there is a capitalist component and a socialist component in the mixture. It also holds that this mixture is precariously unstable – that, sooner or later, it has to end with either full-fledged capitalism or full-fledged socialism (or maybe some other form of statism). It also holds that – since men have free will – the ultimate outcome of this struggle can not be exactly predicted; such prediction would imply determinism. And this in its turn means that the outcome of the struggle depends on what we do now: if we manage to convince enough people, then we can turn the tide; if we don’t, the tide won’t be turned. (All of this should be familiar territory to my readers.)

Schumpeter (who of course knew nothing of Objectivism) nevertheless was aware of those facts: he knew that socialism was inevitable if the trend toward socialism were not broken. He often went wrong in his analysis, and – to be optimistic – he was far too pessimistic in his predictions. So, from this viewpoint, there is some value in studying his ideas.

But to replace Mises and Reisman as guides to economics with Schumpeter would be a disaster.

Published by : Per-Olof Samuelsson, Drakensköldsgatan 3, SE- 632 25 Eskilstuna, Sweden
E-mail: per-olof.samuelsson@swipnet.se
Home page: www.nattvakt.com