Joseph A. Schumpeter

With his notable 1902 study on the pre-1848 relationship between Galician lords and peasants, Mises had started off as a star student in the camp of mainstream historicist economics. When he turned to economic theory à la Carl Menger, he lost the support of this very influential network. After the death of Böhm-Bawerk, academia had little use for the Mengerian tradition that Mises maintained and developed. He would remain outside both the waning tradition of historicism and the emerging influence of neoclassical economists. His work was respected and he enjoyed an excellent reputation, but he was and would remain for the rest of his life an intellectual outsider—his work did not fit into the general development of the science.

The rising star among the young Vienna economists was another member of Böhm-Bawerk's seminar. Two years younger than Mises, Joseph Alois Schumpeter immediately rose to international fame when, barely twenty-five years old, he published a 600-page treatise on economic methodology with the title Wesen und Hauptinhalt der theoretischen Nationalökonomie (The Nature and Essence of Theoretical Economics).¹⁰⁶ In October 1908, he submitted this work to the University of Vienna to obtain a Habilitation degree, which he received under Böhm-Bawerk and Wieser's enthusiastic endorsement in March 1909. Six months later, the twenty-six-year old Schumpeter became Austria's youngest professor of political economy, in the provincial capital of Czernowitz. Two years later, after publishing his second, even more influential book Theorie der wirtschaftlichen Entwicklung (Theory of Economic Development)—he received a full professorship at the prestigious University of Graz. From there Schumpeter began a long and productive academic career that would lead him via Bonn to Harvard.¹⁰⁷ He held several prestigious positions in more practical fields, but each time his involvement was short-lived and ended in debacle. As Austrian Minister of Finance of the second Renner government he was unable to stop the hyperinflation in 1919, and as president of the Biedermann Bank he went bankrupt in 1924.

Joseph A. Schumpeter

Schumpeter's careers in politics and banking were the products of his personal connections. Due to the influence of his stepfather, General Sigismund von Kéler, he was admitted to the prestigious Theresianum gymnasium—the Eton of pre-1914 Austria. There he befriended Rudolf Hilferding, who later became one of the most brilliant Austro-Marxists and a Minister of Finance of the German Reich. Family money also allowed Schumpeter to stay for a year at the newly founded London School of Economics (1906–1907) and to meet Cannan, Marshall, and other British economists. In late 1913 he was a visiting professor at Columbia University and built up a network of contacts in the United States. In the chaotic first months after World War I, Hilferding called Schumpeter, who by then had an excellent international reputation as an economic expert, to join the Commission for the Socialization of German Industry. Schumpeter used the opportunity to prove his political reliability, signing a recommendation to nationalize the German coal mining industry. Shortly thereafter, he became Austrian Finance Minister. Even though he remained in power for only a short time and could realize none of his projects, he at least profited from this engagement on a personal level. He had used his ministerial powers to grant a charter to the Biedermann Bank, which eventually appointed him its president on very comfortable terms. Schumpeter never got involved in managing the bank's daily affairs, but when it went bankrupt in 1924, he felt a deep responsibility toward the stockholders and worked the next eleven years to pay back his debts. He started publishing many paid articles and, when this income proved to be insufficient, accepted a position at Harvard University on very good financial terms.¹⁰⁸

The most important factor in Schumpeter's career, however, was his intellectual excellence. He had a brilliant mind and was a highly gifted writer.¹⁰⁹ He was sensitive to fine distinctions and the subtle problems of economic analysis, which he presented in appealing prose. Although Mises was skeptical of Schumpeter's work on the fundamental issues of economic theory (as were Böhm-Bawerk and many other Austrian economists) he did not hesitate to acknowledge Schumpeter's more penetrating insights and to advance them through his own writings.¹¹⁰ Most notably, Mises was among the many admirers of Schumpeter's colorful portrayal of the role of innovative entrepreneurs in driving social and economic evolution.

Although Mises and Schumpeter were in fundamental disagreement on questions of epistemology and the nature of economic science, they were in essential accord on one subtle but important question: the relationship between economics and psychology. In the mid-nineteenth century, the influential British economist-philosopher John Stuart Mill had popularized an empiricist epistemology according to which all sciences were based on some form of experience. In the case of mathematics and economics, this empirical basis was psychological experience. Mill's epistemology was at first very successful in Austria, where it shaped for example the epistemological views of Friedrich von Wieser. But soon a reaction set in that successfully expelled the Millian approach from central Europe. Around the turn of the century two philosophers, Gottlob Frege and Edmund Husserl, published devastating attacks of psychologism in logic as advocated by J.S. Mill.¹¹¹ Their writings had a considerable impact on the rising generation of Viennese intellectuals in all fields, and Schumpeter spearheaded the movement to drive psychology out of economic theory. He argued that it was futile to inquire after the psychological or biological causes of human valuations; economic analysis could be based entirely on a formal characteristic of valuation, namely, that the utility of any given unit of a homogeneous good decreased as its quantity increased. This purely formal “law of want satiation” had nothing to do with psychology. It was not even a part of economic science proper, but only a convenient hypothesis that explained market prices better than any other. Economists had to take this formal characteristic of valuation as an “ultimate given” of their deductions, and then compare the results of their deductions to the observed real world.¹¹² Mises later argued along very similar lines that the laws of economics had nothing to do with the acting person's psychological disposition, but he disagreed with Schumpeter about the nature of economic laws. For Schumpeter, the only basis for scientific propositions was observation of the exterior world. And the only suitable method of economic enquiry was to follow the approach that had proven successful in the natural sciences. In short, he was a positivist who believed that the only method that could yield “facts” was observation of the exterior world. Mises on the other hand followed the program of Menger's very different “empirical theory” and gathered relevant facts wherever he could find them. Unfortunately, however, Mises had written nothing on epistemology until the late 1920s, and Schumpeter's views had a strong impact on the rising generation.

Around 1900, Schumpeter's epistemological views were much more fashionable than those of Menger and Wieser, and they reinforced the general intellectual and esthetic appeal of his work. His positivism allowed Schumpeter to adopt a lofty attitude of “standing above” the issues of the fierce Methodenstreit.Schumpeter took a completely agnostic stance on the issue of price theory, arguing that from a scientific point of view, it was irrelevant whether prices “really” arose from subjective value or from the costs of production. The subjective-value theory was as he saw it only a hypothesis, and it was to be preferred over cost-of-production theories not because the latter were “false” and the former “true” but because the subjective-value hypothesis served to explain a larger realm of price phenomena than did the cost-of-production hypothesis.

Schumpeter was the first real positivist among economic theoreticians, probably inspired by the works of the Vienna physicist-philosopher Ernst Mach, who was an extremely influential thinker at the time and in the decades to come. Mach paved the way for the Vienna Circle of the Logical Positivists in the 1930s. In The Nature and Essence of Theoretical Economics, Schumpeter fundamentally argued that modern economic science à la Wieser and Walras was a science in the precise sense of Mach's philosophy.¹¹³ He advocated the same views that Milton Friedman presented more than forty years later in his famous essay on economic methodology.¹¹⁴ But while Friedman's presentation was sketchy and detached from the presentation of the actual doctrine, Schumpeter's Nature and Essence made a 600-page case for positivism in economics.

Wieser honored Schumpeter's book with the only review he ever wrote, praising Schumpeter for his achievement in presenting the main contents of economic science.¹¹⁵ Wieser's only admonition was a point that he himself usually considered to be of comparatively minor importance: methodology. He severely criticized Schumpeter's positivist methodology and his rejection of psychological introspection as the foundation of economic knowledge. Wieser claimed that as a consequence of his methodological stance, Schumpeter failed to adequately present the Wesen (the nature) of economic science. Contradicting Schumpeter's claim that he had adopted his method because it best fitted the subject matter of economic research, Wieser stated:

The truth is that—without knowing it—he brings in his ready-made methodology from outside.... Blinded by the success of the exact natural science he adopts its way of thinking even where it does not at all fit our subject matter, and thus construes an artificial method with which he would never have been able to arrive at the results that he wants to take over from his predecessors.¹¹⁶

Wieser then brilliantly addresses Schumpeter's claim that the fundamental economic theorems have the character of hypotheses. He states that the hypotheses of the natural sciences are assumptions about unknowns, whereas the assumptions of economic science always have known real-world correlates, even though they may not always reflect them faithfully. He distinguishes two types of assumptions made by economists: isolating assumptions and idealizing assumptions. The former are needed to engage in Gedankenexperimenten or thought experiments;¹¹⁷ they serve to describe the state of affairs that is the subject of theoretical analysis:

Just like the natural scientist in an experiment, we must make isolations in our mental observations. Complex experiences cannot be interpreted as a whole. We must decompose them into their elements to understand their meaning. Only then are we in a position to deduce the total effect through a composition of the separate particularities.¹¹⁸

These isolations must however be strictly realistic because their usefulness depends entirely on their truthfulness. In contrast, the idealizing assumptions do not truthfully reflect a real correlate but deliberately transform it into an “ideal” form—such as homo oeconomicus.¹¹⁹ Thus even in this contestable (and, as Wieser admits, highly contested) form, the fundamental assumptions of economics always have a known real-world correlate in human consciousness. Refusing to make use of them, as Schumpeter suggests, would result in incomplete and ultimately unconvincing economic arguments.¹²⁰

Despite these objections to Schumpeter's misdirected methodology, Wieser praised Nature and Essence:

While [Schumpeter] quickly passes over all those subjects that he thinks others have sufficiently presented, he lingers on the more difficult problems. Having begun his studies of economics only a few years ago, he may say with just pride that his book is not written for beginners, but presupposes quite an exact knowledge of the state of our science.¹²¹

Schumpeter's appearance, and his promotion through both Wieser and Böhm-Bawerk, was an important development in the emergence and consolidation of an international network of economic theorists following in Gossen's footsteps. Schumpeter built on the foundations laid by Wieser, making the German-speaking economic scene safe for what today is known as neoclassical economics. Whereas Wieser had further developed the theory of Jevons, Schumpeter brought Walras to Vienna. Having thought through the implications of the doctrine of natural value, he discovered important and far-reaching affinities between Wieser's system and the general-equilibrium framework developed by Léon Walras in Lausanne. Both Jevons and Walras had developed a theory of price determination under fictional “ideal” conditions, disregarding various essential features of the human economy that Menger and to a lesser degree Böhm-Bawerk had carefully sought to integrate in the new price theory. For instance, both Walras and Wieser considered human error to be a mere “friction” preventing the real world from following the course it should take; and they both implicitly denied that all quantities of economic goods were essentially related (as private property) to human beings, and that the utility or value of a good was essentially related to the specific situation of the person evaluating the good. Both Walras and Wieser conceived of price determination as the mechanistic interplay of freely floating quantities and of equally freely floating (and measurable) utilities. This explanation of economic phenomena is general-equilibrium theory—implicit in Wieser and explicit in Walras.

In Nature and Essence, Schumpeter gave a refined and largely verbal restatement of general-equilibrium theory. He remedied certain shortcomings of Walras and Wieser, for example, by accounting for the fact that all quantities of goods are owned quantities, and he came very close to presenting economic science as the science of human choices when he argued that the nature of economic action is exchange. Ludwig von Mises, Richard von Strigl, and Lionel Robbins would develop this insight and argue that the fundamental economic phenomenon was the act of preferring one thing over another thing, and that virtually all economic laws in one way or another relate to this phenomenon.¹²²

Schumpeter spent most of his book discussing methodological and epistemological questions, in the course of which he gave the first succinct descriptions of methodological individualism and the method of variations (comparative statics)—terms that he coined. He dealt with economic laws only incidentally, using them as illustrations for his methodological and epistemological claims. His most fateful contribution was to recast the entire general-equilibrium theory in terms of a distinction he borrowed from classical mechanics between statics and dynamics. According to Schumpeter, the “static” economy and the “dynamic” economy are entirely different states of affairs; they present different problems and require different methods of analysis.¹²³ Schumpeter was not the first economist to stress the usefulness of analyzing static and dynamic economic conditions separately. The American economist John Bates Clark had pioneered this approach a few years earlier in his book The Distribution of Wealth, which proved to be very influential among Vienna economists. But Schumpeter produced a mechanistic interpretation of the static-dynamic scheme, holding that in a truly static economy all events of a given day are only repetitions of whatever happened the previous day. He claimed moreover that past economists had dealt exclusively with static conditions, which are the proper subject matter of general equilibrium theory. Dynamic conditions remained virtually unexplored, and economists had yet to even recognize the related problems.

Schumpeter attempted to fill the gap with his Theory of Economic Development, which he published in 1911, a year before Mises published his first major work. The book was the dynamic complement so to speak to Nature and Essence, which had focused exclusively on static conditions. The second book contained three major theses.

First, Schumpeter argued that economic development was exclusively the result of pioneering “entrepreneurs”—a special breed as different from the rest of mankind as greyhounds are from poodles. Innovative entrepreneurs are the true driving force of social evolution. They impose unheard-of products and methods of production on a reluctant society of mere adjusters. It was this thesis in particular that roused the admiration of Schumpeter's friends and colleagues. Twenty years later, Mises listed the book as one of the top four German-language contributions to economics.¹²⁴ It has continued to fascinate some of the best Austrian economists to the present day.¹²⁵

Second, Schumpeter portrayed entrepreneurs as essentially resourceless market participants. They needed new fiduciary bank credit (“credit out of thin air”) to finance their projects because all other investment capital was already tied up in other projects. For Schumpeter, capital was essentially “purchasing power” rather than a quantity of real goods that could sustain workers in the production process. Bankers could therefore create “capital” out of nothing by simply printing additional banknotes.

Third, and most importantly, he asserted that under static conditions the phenomenon of interest would not exist. Interest paid on capital invested could only come into being under dynamic conditions, that is, as a result of change. Its primary form was entrepreneurial profit. By contrast, the interest paid on bonds or on bank credits was just a share of profits that entrepreneurs were forced to pay to bankers to secure their cooperation. Schumpeter contested in particular Böhm-Bawerk's theory, according to which time preference creates interest even under static conditions. Arguing along the lines of John Bates Clark, Schumpeter insisted that the passage of time is irrelevant to production under static conditions because consumption and investment are always “synchronized.”

Schumpeter's first thesis—that entrepreneurship drives progress—has proven to be the least controversial, but with the other two contentions he opened a Pandora's box of old errors that six preceding generations of brilliant economists, among them his own teachers, had spent their lifetimes fighting.

Böhm-Bawerk immediately recognized the dangerous impact that these skillfully presented views were to have in the future. He wrote a long review of Theory of Economic Development in an attempt to offset the damage being done by one of his most gifted students. Böhm-Bawerk made it clear that Schumpeter's “dynamic” theory of interest was completely wrong. Moreover, Schumpeter's economic analysis suffered from a sloppiness that belied the author's great intellectual gifts. One of the review's opening paragraphs came close to charging Schumpeter with a lack of professional integrity:

Schumpeter has taken pleasure in contemplating an ingenious idea, but unfortunately he has not had the self-discipline [Selbstüberwindung] to subject himself and his idea to a sober and encompassing cross-examination, an examination that very soon would have shown problems on all sides.¹²⁶

After dissecting some of the most important shortcomings of the Theory of Economic Development in detail, Böhm-Bawerk went on to identify the spirit of Schumpeter's work:

I do not intend to give a running critique of all of Schumpeter's ideas. I am content with briefly expressing my conviction that Schumpeter commits a fateful mistake, which despite all the qualifications that he makes is a true mercantilistic mistake of superficial reasoning: When it comes to determining the possible scope of productive credit, he accords the essential role to money and means of payment, rather than to the economy's supplies of real goods. Schumpeter is much closer than he thinks—and, maybe, than he wishes—to the Laws and McLeods and regrettably he is quite removed from Hume, despite all the praise that he has for the latter.¹²⁷

Böhm-Bawerk went to great lengths in refuting the doctrines of his former disciple. He knew that ideas have consequences, and that fallacious ideas can ruin a country or an entire civilization if they are presented with the grace and vigor of Schumpeter's works. Unfortunately, Böhm-Bawerk died a year later and the mantle passed to Wieser and Schumpeter. Both would make sure that the next generation of Viennese economists would be part of the emerging neoclassical synthesis.