CHAPTER 13 Schumpeter’s Theory of Economic Development

Joseph A. Schumpeter always took the middle ground in areas of politics and academics. His work cannot be readily categorized even today. He felt himself obliged to the Austrian School, on the one hand, and when he got to Harvard, was happy to introduce American students to Austrian teachings. But he also made all kinds of concessions to socialism, holding the German Historical School and Gustav Schmoller in particularly in high esteem in the 1920s (cf. Schumpeter 1926). When he was twenty-eight he tried to weave together these different traditions in the later-famous Theorie der wirtschaftlichen Entwicklung (1912) (The Theory of Economic Devolopmeni). As a starting point he applied the equilibrium theory of Lausanne economist Léon Walras (1834–1910), which stands in marked contradiction to the thinking of the Austrian School. Unlike Walras, however, Schumpeter was of the view that a static theory alone was insufficient to fully explain economic phenomena. In the preface to the Japanese edition of his Theory of Economic Devolopment, he noted that one would have to assume “a source of energy within the economic system” that would upset the equilibrium of economies, as external factors alone could not be made responsible for such a change (Schumpeter 1937/1989, p. 166). Furthermore, in his strongly psychology-biased description of the role of entrepreneurs, Schumpeter drew on the groundwork of the Berlin political economists, Adolph Friedrich Johann Riedel (1809–1872) and Albert Eberhard Friedrich Schäffle, neither of whom, however, he cited (cf. Streissler 2000a, pp. 103–104 and Kurz 2005, p. 50).

Schumpeter’s original German Theorie der wirtschaftlichen Entwicklung has been published nine times to date. It has been translated into numerous languages, including Italian, French, Polish, Brazilian, Japanese, Russian, Slovak, and Hungarian (cf. Augello 1991, pp. 448–453), with a considerable number of reprints in several of those languages as well. Schumpeter streamlined the original text so radically in the second edition (1926) that it almost became a new book (cf. Röpke and Stiller 2006, pp. v–vi). The 1926 version gave birth to many of the memorable expressions that appear, largely unchanged, in later editions. As a rule, discourse in the German speaking world refers to the second or later editions. The book was received in the Anglo-American world in the form of an abridged, “rewritten,” and imprecise translation from 1934, also based on this second edition: The Theory of Economic Development (1934). The remarkable consequence is that the original text remains largely unknown to this day; indeed Schumpeter’s name is linked in many cases to theses which he had explicitly opposed in his original work (ibid., pp. viii–ix).

Schumpeter, who proceeded on the assumption of a categorical distinction between static and dynamic economics, stated from his second edition on more precisely that “economic development” should not be understood as making the necessary adjustments, but in terms of those adjustments “by which economic life itself changes its own data by fits and starts” (Schumpeter 1912/1934/1961, p. 62). These changes would come about while implementing new combinations of production goods: the manufacturing of a new product, for example, or the introduction of a new production method, the opening up of a new market, access to a new source of natural resources, or the creation or breaking of a monopoly (ibid., p. 66). These processes of “industrial mutation,” which “continuously revolutionize the economic structure from within,” wrote Schumpeter, amount to a process of creative destruction and constitute the essential reality of capitalism (Schumpeter 1942/1976, pp. 82–83). To be in a condition of dynamic imbalance is in the nature of capitalist markets. Old structures are periodically replaced by new. If a capitalist society were in equilibrium, it would be doomed. In this sense, “innovation” and “creative destruction” are its pivotal features.

It is ultimately the entrepreneurial will—the entrepreneur’s leadership —that spurs on economic growth and social change. Schumpeter stated in the original German edition that entrepreneurs even force their products onto the market (Schumpeter 1912/2006, p. 133). But in the fewest of cases are entrepreneurs themselves also creators. It is not part of the entrepreneur’s function “to ‘find’ or to ‘create’ new possibilities. They are always present, abundantly accumulated by all sorts of people…. Plenty of people as a matter of fact did see it. But nobody was in a position to do it. Now, it is this ‘doing the thing,’ without which possibilities are dead, of which the [entrepreneur’s] function consists” (Schumpeter 1912/1934/1961, p. 88, emphasis in the original). In the first volume of his Business Cycles (1939) (German Konjunkturzyklen, 1961), Schumpeter repeated that without doubt, “the great majority of changes in commodities consumed has been forced by producers on consumers.” In most cases, the consumers would have resisted and would have first had to be educated “by elaborate psychotechnics of advertising.” “Railroads did not emerge because some consumers took the initiative in displaying an effective demand for their service in preference to the services of mail coaches. Nor did consumers exhibit the wish to have electric lamps or rayon stockings, or to travel by motorcar or airplane, or to listen to radios, or to chew gum” (Schumpeter 1939, p. 73).

Today’s well-known description of the entrepreneur’s motivation took shape in Schumpeter’s revised second edition of the Theorie der wirtschaftlichen Entwicklung (1926). The English version of this passage dissented slightly from the German original in that it omitted the naïve and quixotic undertone in the character sketch of the entrepreneur. Apart from that, the quintessence was preserved in the translation: “First of all, there is the dream and the will to found a private kingdom, and usually, though not necessarily, also a dynasty…. Then there is the will to conquer: the impulse to fight, to prove oneself superior to others, to succeed for the sake… of success itself…. From this aspect economic action becomes akin to sport— there are financial races, or rather boxing-matches…. Finally, there is the joy of creating, of getting things done, or simply of exercising one’s energy and ingenuity. This is akin to a ubiquitous motive, but nowhere else does it stand out as an independent factor of behavior with anything like the clearness with which it obtrudes itself in our case. Our type seeks out difficulties, changes in order to change, delights in ventures” (Schumpeter 1912/1934/1961, pp. 93–94).

Schumpeter’s fundamental distinction between “entrepreneurs” and their imitators—those he called “mere managers”—can be traced back to the leadership-elite theory of his teacher Friedrich von Wieser. According to Wieser, only “people of a very special kind” occupy an “exceptional position” by having the “courage to innovate” and the desire to form “the world in their image.” They play the part of the trendsetter in the world of fashion, but also as “founders of joint-stock companies,” as “leaders of political parties,” or as “strike-leaders” (Wieser 1910, p. 26). “Leading and following,” writes Wieser, “is the basic form of all social action. Masses do not unite because of contracts… they unite through leading and following” (ibid., p. 31). Although Wieser understood “leadership” in terms of social function rather than in terms of people’s drives or character traits (cf. Wieser 1925 and 1927a), Schumpeter placed special emphasis, even in the first edition, on the psychological profile of the “business leader.”

The psychological side of the entrepreneurial portrait was tied unmistakably to Friedrich Nietzsche (1844–1900), and also to Max Weber’s (1864– 1920) “charismatic leader” or Oswald Spengler’s (1880–1936) “Faust-like” human being—bringing to mind the emerging leader cult in Germany. In the first (German) edition, Schumpeter saw the entrepreneur as analogous to the creative artist and thinker (cf. Schumpeter 1912/2006, pp. 24–25, 133, 142, 148) or described him as “chieftain specializing in business matters” (ibid., p. 173). But from the second edition on, he placed more emphasis on the function of the entrepreneur. What he depicts is an elite that enjoys flaunting its accomplishments and strengths, and molds social reality, casting a spell over it with restless ambition (Schumpeter 1926b [1913], p. 137). Members of this elite can be found among property owners or company founders; but the “leading man” might also be a manager, a majority share owner, or even someone who has no capital at his disposal: “It is leadership rather than ownership that matters” (Schumpeter 1939, p. 103).

In order to produce something innovative and to offer it on the market, an entrepreneur would have to withdraw already existing production goods from their previous use. For this purpose, he would need “purchasing power” but he seldom possesses the needed investment capital. The entrepreneur does not usually save up to acquire the necessary means, “nor does he accumulate any goods before beginning to produce” (Schumpeter 1912/1934/1961, p. 136). So funding is necessary in order to introduce new combinations. Entrepreneurs could only invest with the help of credit. Such “credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power” (ibid., p. 107). Accordingly, it is ultimately the banker who enables the introduction of new combinations, who “authorizes people in the name of society, as it were, to form them. He is the ephor of the exchange economy” (ibid., p. 74, emphasis in the original).

The entrepreneur, writes Schumpeter, “is never the risk bearer…. The one who gives credit comes to grief if the undertaking fails…. Risk-taking is in no case an element of the entrepreneurial function. Even though he may risk his reputation, the direct economic responsibility of failure never falls on him” (ibid., p. 137). It applies that the lender—the banker—simply transfers “purchasing power,” yet by no means actual stock. In the original German version Schumpeter had still noted, somewhat unassertively, that one could say “without any great sin” that the “banker creates money” (Schumpeter 1912/2006, p. 197); later, in the English edition, this self-absolution was retained. After the second German edition, Schumpeter refined the language of his explanatory model even further: “It is always a question, not of transforming purchasing power which was already in someone’s possession, but… of the the creation of new purchasing power out of nothing” (Schumpeter 1912/1934/1961, p. 73). This is the source from which new combinations are typically financed; ultimately an innovator “can only become an entrepreneur by previously becoming a debtor” (ibid., p. 102).

With the help of loans, an entrepreneur could crush the attempts of others and establish his new products on the market. This would provide him with substantial profits. Since he “has no competitors when the new products first appear, the determination of their price proceeds wholly, or within certain limits, according to the principle of monopoly price” (ibid., p. 152). But his success would soon attract imitators; his profit margin would in turn decrease, and soon give way to the competition. The entrepreneur’s profit “slips from the entrepreneur’s grasp as soon as the entrepreneurial function is performed. It attaches to the creation of new things, to the realisation of the future value system. It is at the same time the child and the victim of development” (ibid., pp. 153–154). The appearance of imitators taking advantage of the pioneering work of the entrepreneur would on balance cause an economic boom. This would be evident in the creation of new jobs, on the one hand, and in wage increases and a higher interest rate on the other. But this would also result in a decrease in the demand for credit, and many of those new companies—in contrast to established ones which can fall back on accumulated resources—would go bankrupt. In other words, the wave of innovation would again subside and the economy would slide into crisis. After a period of economic recession, innovative entrepreneurs would again emerge in some branches of industry and the cycle would begin anew.

The idea that the modern economy is mainly financed with the help of credit had been discussed years earlier by Rudolph Hilferding in Böhm-Bawerk’s seminar (cf. “fictitious credit,” Hilferding 1910/1981, pt. 2); Hilferding published the same, but Schumpeter made no reference to it. Even at that time critics thought it was easy to prove empirically that innovations were indeed not (or by no means exclusively) financed by debt. All in all, Schumpeter’s Theory of Economic Development enjoyed a mixed reception (Röpke/Stiller 2006, p. x). He later remarked that the book had been rejected generally (cf. McCraw 2007, pp. 534n. 23). Schumpeter’s denial of capital interest in static economics and his thesis of the inflationary financing of innovative production processes elicited displeasure on the part of his former teacher, Eugen von Böhm-Bawerk, who in a lengthy critique warned against the “danger of false teaching presented in such a disarming manner—full of spirit and eloquence” (Böhm-Bawerk 1913a, p. 61). Schumpeter’s meek response (Schumpeter 1913) and Böhm-Bawerk’s rejoinder (Böhm-Bawerk 1913b) showed all too clearly how deep the rift between Schumpeter and the Austrian School had grown.

After World War I, the Austrian School got to the bottom of the link between credit financing and business cycles. Unlike Schumpeter, its members saw in the creating of purchasing power “out of thin air” a beguiling illusion that would undermine and ultimately distort the workings of the economy (cf. Machlup 1931/1940, pp. 172–173; Hayek 1929/1933, p. 189). Schumpeter’s Theory of Economic Development nevertheless enjoyed a remarkable renaissance in the last decades of the twentieth century. It served as the inspiration for what is called “evolutionary economics,” and also modern research on innovation (Kurz 2005, pp. 61–65).

With his work, Capitalism, Socialism and Democracy (1942/1976), written during World War II, Schumpeter dedicated himself, among other things, to the question of whether capitalism can survive in the long term. Schumpeter answered in the negative. Large corporations would take on the role of innovator more and more. Key decisions would no longer be made by ambitious small entrepreneurs driven by their desire for social advancement, but by paid managers: “Instead of lively contact between all people and things involved in production,” Schumpeter had already written in Sozialistische Möglichkeiten von heute (1920–1921) (“Socialist Prospects of Today”), there would be “ever more administration from some distant board room” (ibid., p. 319). And the capacity for technical innovation increases with the size of the company. It will be systematically undertaken by research and development departments of large businesses. Finally, in the late capitalist era, business administrators, whose actions generally resemble those of civil servants, rather than innovative entrepreneurs, would drive the economy: “Everywhere we find industries which would not exist at all but for protection, subsidies, and other political stimuli, and others which are overgrown or otherwise in an unhealthy state because of them” (Schumpeter 1939, p. 13). The classic entrepreneur will be left with no arena in which to operate. Bureaucratic capitalism will slowly metamorphose into centrally planned socialism.