Schumpeters Theory of Economic

Wednesday, March 13
th
2013
University of Kragujevac
Prof. Dr. Harald Hagemann, University of Hohenheim, Stuttgart
Schumpeters Theory of Economic
Development
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Joseph A. Schumpeter (1883 - 1950)
1908:
Habilitation in Vienna
Das Wesen und der Hauptinhalt der theoretischen
Nationalkonomie
1909:
a.o. Professor Czernowitz
1911:
Professor Graz
1912:
Theorie der wirtschaftlichen Entwicklung
(1934 Theory of Economic Development)
2
Theorie der wirtschaftlichen Entwicklung
(1934 Theory of Economic Development)
1919:
Austrian Finance Minister
1921:
President Biedermann Bank
1925:
Professor, University of Bonn
1932:
Harvard University
1939:
Business Cycles: A Theoretical, Historical, and Statistical
Analysis of the Capitalist Process (German 1961)
1942:
Capitalism, Socialism and Democracy
1954:
History of Economic Analysis
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
In the Preface to the first German edition of The Theory of
Economic Development Schumpeter (1911, p. VIII) points out
that he had started his analysis with the concrete theoretical
issues involved in the crisis problem in 1905. Furthermore, he
makes clear that this book and his earlier one on Das Wesen
und der Hauptinhalt der theoretischen Nationalkonomie
Schumpeters Theory of Economic Development (1)
3
und der Hauptinhalt der theoretischen Nationalkonomie
(The Nature and the Main Content of Theoretical Economics)
(Schumpeter 1908) form an entity, although the second one
can be read independently of the first one. The division of
labour between the two books can be understood best with
regard to the two masters Walras, Schumpeter's great hero,
and Marx, whose views on the long-run development of the
capitalist economy form a life-long challenge for Schumpeter.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
In the Preface to the Japanese edition he emphasizes that
Walras provided us with a theory which embraces "the pure
logic of the interdependence between economic quantities",
whereas Marx's genuine contribution to economics is "a
vision of economic evolution as a distinct process generated
Schumpeters Theory of Economic Development (2)
4
vision of economic evolution as a distinct process generated
by the economic system itself" (Schumpeter 1937, pp. 165-
6). This corresponds to the distinction between static and
dynamic analysis, which plays a major role in his work. Due
to the influence of Frisch in contrast to the 1926 German
edition in the 1934 English edition the terms statics and
dynamics are fully replaced by the concepts of the circular
flow and economic development
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Schumpeters Triad
Accordingly, Schumpeters economic dynamics deals with
the changing of the data of the static system, or the
destruction of the circular flow by the carrying out of new
combinations that includes the five cases of the
introduction of new methods of production, new products, the
Schumpeters Theory of Economic Development (3)
5
introduction of new methods of production, new products, the
opening of new markets, new sources of supply, and new
forms of organization. In Schumpeters system economic
dynamics is strongly linked to the phenomenon of economic
development. The main carrier of economic development is
the pioneering entrepreneur, who is an endogenous force
in the economy and in marked contrast to the great majority
of people limited to taking routine actions only.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
In Schumpeters view not only the final chapter 6 but in fact
any single page of his Theory of Economic Development is
dedicated to the problem of the business cycle, and
analyzing business cycles means neither more nor less than
analyzing the economic process of the capitalist era
Schumpeters Theory of Economic Development (4)
6
analyzing the economic process of the capitalist era
(Schumpeter 1939, p. V). Economic Development in the
sense of Schumpeter is endogenous, spontaneous and
discontinuous. It is the task of dynamic theory to explain the
origin and effects of these transition processes which
essentially are a disturbance of equilibrium.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
The importance of innovations and credit is at the
very center of Schumpeters Theory of Economic
Develop-ment. As Streissler has emphasized, it
were not the figure of the pioneering entrepreneur
Credit and Innovations in Schumpeters BCT (1)
7
were not the figure of the pioneering entrepreneur
and the importance of bank credit for economic
development that were new in Schumpeter but
rather the idea of creative destruction by
innovations and the notion that bank credit was
the prerequisite of innovations and of the
foundation of new enterprises.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
The innovating entrepreneurs need financial means for their
investment activity which is given to them in form of credit by
the banking system. Schumpeter shares Wicksells view that
the disturbance of economic equilibrium primarily emerges
Credit and Innovations in Schumpeters BCT (2)
8
the disturbance of economic equilibrium primarily emerges
because of an enlargement of profitable investment options,
leading to an increase of the natural rate of interest in
Wicksells Interest and Prices (1898), rather than by a
lowering of the money rate of interest below the level of
the natural rate by the banks, thereby causing a period of
expansion which is unsustainable.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Credit and Innovations in Schumpeters BCT (3)
The latter is emphasized in the works of his two
compatriots Hayeks Prices and Production and Misess
Theory of Money and Credit. There, the bust is the
inevitable consequence of the credit-induced boom in
which the reallocation to excessively roundabout
9
which the reallocation to excessively roundabout
methods of production is corrected. Misess argument of
excessive credits by the banking sector as the decisive
cause of cyclical fluctuations is most clearly stated in his
Monetary Stabilization and Cyclical Policy (1928), in
which he not only distances himself from views still held
by Schumpeter but even from his own earlier views.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Schumpeters assumption that available resources are fully utilized
in the stationary circular flow implies that the carrying out of new
combinations requires a different employment or reallocation of these
resources. The entrepreneur must resort to credit if she wishes to carry
out new combinations since they cannot be financed by the returns
from established production activities. Schumpeter also considers
Credit and Innovations in Schumpeters BCT (4)
10
from established production activities. Schumpeter also considers
saving as a result of previous development. The financing of
innovations by means of credit is the function of the banking system.
In Schumpeters view the banker is not the trader but the producer
of purchasing power. [C]redit is essentially the creation of purcha-
sing power for the purpose of transferring it to the entrepreneur, but not
simply the transfer of existing purchasing power
(Schumpeter 1934, p. 107).
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
The consequence of the creation of new purchasing power
out of nothing, i.e. not rooted in previous savings, is an increase of
aggregate demand in monetary terms, which leads to an increase in
prices. The credit-induced inflation acts as a tax on the mere managers
stiffened in routine actions thereby implying a reallocation of productive
Credit and Innovations in Schumpeters BCT (5)
11
stiffened in routine actions thereby implying a reallocation of productive
resources. Although interest on capital is a monetary phenomenon,
it is ultimately based on a real factor: the productivity-enhancing
effects of innovations. Schumpeter thus makes forced savings,
which play an important role in the analyses of his contemporaries
Wicksell, Mises, Hayek and Robertson (imposed lacking) but were
already an argument in Henry Thornton as early as 1803, an integral
part of his theory.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
However, in contrast to Mises and Hayek who were adherents
of the orthodox doctrine that only voluntary savings can create
sustainable capital and held the view that the granting of a volume of
credit which transcends the level of voluntary savings by the banking
system inevitably leads to a crisis, the creation of money and credit for
Credit and Innovations in Schumpeters BCT (6)
12
system inevitably leads to a crisis, the creation of money and credit for
Schumpeter is an essential condition for the financing of innovational
activities and thus development in competitive capitalism. Moreover,
the credit system is no very active factor in the mechanism of cycles.
It adapts itself to the demand which comes from entrepreneurs and
submits to contraction by their repayment of loans. In both cases its
role is rather a passive one (Schumpeter 1931, p. 17).
idea of endogeneity
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Schumpeter opposed the idea that the succession of prosperity and
depression is a purely monetary phenomenon. Three factors are
considered:
1. The competition for the scarce means of production causing price
increases of investment goods in the boom.
Credit and Innovations in Schumpeters BCT (7)
13
2. The decline in prices when the new products enter the markets as
the consequence of the enlarged productive capacities, thereby
making a depression unavoidable.
3. Then the entrepreneurs use their returns for paying back their debts
causing a credit deflation just in that period when the additional goods
which could take away inflationary pressure as a consequence of the
abnormal credit inducing the boom could be produced in a regular
manner.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Schumpeters views found the most innovative resonance in the
contemporary German literature in Lucien (L.) Albert Hahns
Volkswirtschaftliche Theorie des Bankkredits (Economic Theory of
Bank Credit) (1920), a fact which is explicitly emphasized by
Credit and Innovations in Schumpeters BCT (8)
14
Schumpeter in the second edition of TED when he refers the reader
to Hahns original and meritorious book, which has essentially
advanced our knowledge of the problem at the beginning of his
discussion of the nature and function of credit (Schumpeter 1934,
p. 95, fn. 1).
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Hahn emphasizes, as later Keynes, the deflationary effects of voluntary
savings and the positive effects of an expansionary credit policy for
innovations and employment. A key statement reads:
Capital formation is not the result of saving but of credit.
L. Albert Hahns Economic Theory of Bank Credit
15
Capital formation is not the result of saving but of credit.
(Hahn 1920, p.120)
Hahn takes up Schumpeters distinction between normal and
abnormal credit and elaborates the distinction between
non-inflationary credit (in the amount of overall savings) and
inflationary credit due to the money-creating ability of the banking
sector.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
However, Schumpeter (1926) in the 2
nd
German edition of TED, feels
obliged to keep some distance from Hahn, whose much stronger
emphasis on the directly production-enhancing effects of an
inflationary credit creation caused his accusation as an inflationist,
when he points out: Against his formulation it appears to me correct to
Schumpeter vs. Hahn (1)
16
when he points out: Against his formulation it appears to me correct to
say: although not by existing goods, the quantity of new purchasing
power that it is possible to create is supported and limited by future
goods. (p. 165)
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
It is clear that for Schumpeter the spending of credit for innovative
investments is decisive, not for increased consumption. This becomes
particularly evident in his statements on capital which is regarded as a
fund of purchasing power.
Schumpeter vs. Hahn (2)
17
fund of purchasing power.
Capital is nothing but the lever by which the entrepreneur subjects to his
control the concrete goods which he needs, nothing but a means of
directing the factors of production to new uses, or of dictating a new
direction for production. (TED 1934, p.116).
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
In his Business Cycles, Schumpeter (1939) distinguishes four phases of
economic fluctuations: prosperity, recession, depression and recovery, and
presents a three-cycle schema, in which Kondratieff long-waves constitute
the framework where they are combined with the classical Juglar and the
shorter Kitchin cycles. In the preface to the English edition of TED we find
The Business Cycle as a Superposition of Different Waves (1)
18
shorter cycles. In the preface to the English edition of TED we find
the following statement: I took it for granted that there was a single wave-
like movement, viz. that discovered by Juglar. I am convinced now that there
are at least three such movements, probably more, and that the most
important problem which at present faces theorists of the cycle consists
precisely in isolating them and in describing the phenomena incident to their
interaction. But this element has not been introduced into the later editions
(1934, p. IX).
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
This statement is not surprising because the Kitchin and the
Kondratieff cycle were born in the economic literature only in the
1920s. Schumpeter himself was the co-editor of the journal in which
Kondratieffs famous article on The long waves in economic life was
published in German in 1926. However, it is quite interesting to notice
The Business Cycle as a Superposition of Different Waves (2)
19
published in German in 1926. However, it is quite interesting to notice
that the idea of superposition of different complexes of causality was
already there when Schumpeter presented the main ideas on the
wave-like fluctuation in economic activity to the Harvard faculty
shortly before the outbreak of World War I.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Kondratieff (1)-,
Juglar (2)- and
Kitchin (3)-Cycles
The Business Cycle as a Superposition of Different Waves (3)
20
Source: Schumpeter (1939), p. 213
Schumpeters basic idea that cyclical
fluctuations consist of many waves:
a composite of three cycles of different
length.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Business and Growth Cycles (1)
Business Cycles
- Kitchin cycle Length: 3-5 years
Inventory investment
- Juglar cycle Length: 7-11 years
Machinery equipment
21
Machinery equipment
Growth Cycles
- Kuznets cycle Length: 15-25 years
Investment in buildings
- Kondratieff cycle Length: 45-60 years
Basic capital innovations
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Business and Growth Cycles (2)
The jerky character of economic evolution can hardly be denied
and it is one of Schumpeters great merits to emphasize the
importance of integrating the study of business cycles with an
analysis of long-run economic development which does not
follow a steady-state or balanced growth path. Innovations are
22
not only the decisive impulse of cyclical fluctuations but the period
of their implementation also determines the different length of the
cycles. With some qualification with regard to the Kitchin the
simultaneous presence of cycles of different order for Schumpeter
is a problem of interference only and not a problem of different
causation.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Business and Growth Cycles (3)
Schumpeters monocausality argument also is at odds with the
later understanding of economic theory that the cycles of different
duration are related to different types of investment goods as the
causal factor, i.e. that we have to distinguish between fluctuations
in inventories (Kitchin), fluctuations in fixed capital investment
(Juglar or Marxs echo effect), fluctuations in construction
23
(Juglar or Marxs echo effect), fluctuations in construction
investment (Kuznets) and fluctuations in basic capital goods as
the medium for basic innovations (Kondratieff). Although
Schumpeter was willing to consider and integrate the most recent
and important developments in economic theory, he clearly did
not want to change his early vision laid down in his theory of
economic development.
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Business and Growth Cycles (4)
Name Kitchin
cycle
Juglar
cycle
Kuznets
cycle
Kondratieff
cycle
Type
Business
Cycle
Business
Cycle
Growth
Cycle
24
Cycle Cycle Cycle
Long Waves
Length
3-5 years 7-11 years 15-25 years 45-60 years
Causal
Factor
Fluctuations
in inventories
Fluctuations
in fixed
capital
investments
Fluctuations
in
construction
investments
Fluctuations
in basic
innovations
and/or basic
capital goods
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Long Waves of Economic Cycles (1)
Long
Waves
Important Innovations Prosperity Recession Depression Recovery
1.
Industrial Revolution
(Division of labour,
steam engine)
1782-1802 1802-1825 1825-1836 1836-1845
2.
Railroads, Steel
Mechanization
1845-1866 1866-1872 1872-1883 1883-1892
25
Mechanization
3.
Electricity,
Automobiles, Chemical
Industry
1892-1913 1914-1929 1929-1937 1938-1948
4.
Atomic Energy,
Computer, Robots,
Electronics
1948-1966 1966-1973 1973-1982 1982-1995
5.
Information and
Communication
Technologies,
Biotechnologies
1995-
UNIVERSITY OF HOHENHEIM
PROF. DR. HARALD HAGEMANN
Long Waves of Economic Cycles (2)
In the lost seventh chapter of the first German edition
of The Theory of Economic Development (Schumpeter
1911) Das Gesamtbild der Volkswirtschaft (The Overall
View of the Economy), Schumpeter had analysed
already the theoretical and historical development
26
already the theoretical and historical development
problem and emphasized the importance of statistical
analysis. He recognized that economic development is
essentially discontinuous since innovations arise
unevenly over the various industries. Entrepreneurs are
followed by many imitators so that innovations tend to
cluster.