Schumpeter's Revolution

"I'm afraid I cannot hold out against the new technology any longer." With these words, the Economist announced in 2010 a new weekly management blog, Schumpeter, to accompany the recently inaugurated print column bearing the same name.¹ The eponymous columnist wrote that, like his namesake, he was ambivalent about technology — "a technophile technophobe."² Schumpeter saw technological upheaval as the essential fact about capitalism. It is not necessarily good or bad; it is relentless and irresistible.

The economics profession has found Schumpeter's insight compelling in recent decades. According to an analysis published in 2009 in the Journal of Economic Thought, since about 1995, Schumpeter has received more citations in the social science literature than John Maynard Keynes, and the difference has increased annually. "For social scientists, since the mid-1990s, annual citations to [Schumpeter's] Capitalism, Socialism and Democracy have even exceeded annual citations to Keynes’s General Theory."³

Joseph Schumpeter, born in Austria in 1883 (the same year as Keynes), coined the phrase “creative destruction.” He described a “process of industrial mutation … 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. It is what capitalism consists in and what every capitalist concern has got to live in.”⁴

The great attention Schumpeter now receives acknowledges the importance of his research — both historical and theoretical — into the substitution of one technological regime by another, for example, the way railroads replaced canals and the trucking industry challenged railroads. Another aspect of Schumpeter's analysis, however, is less recognized. Neoclassical, or “mainstream,” economists believe that concepts such as the profit motive, price com­petition, demand curves, and utility functions explain the behavior of markets. If the process of creative destruction is the true essence of capitalism, however, then these orthodox or mainstream concepts become less essential. How can there even be an economic theory or a mathematical model of creative destruction?

The essence of capitalism for Schumpeter lay in the rambunctious technological change through which innovations that may be previously inconceivable overturn whole industries, replace entire ways of doing things, and create unimaginable kinds of goods and services. “The fundamental impulse that sets and keeps the capitalist engine in motion,” he wrote, “comes from the new consumer’s goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.”⁵

Schumpeter argued that neither price competition nor the profit motive are essential to capitalism or innovation. He wrote, "Economists are at long last emerging from the stage in which price competition was all they saw …. It is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization … which strikes not at … the profits … of the existing firms but at their foundations and their very lives."⁶

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Schumpeter is the only pro-capitalist economist in the 20^th century to be influenced more by Karl Marx than by Adam Smith. In The Communist Manifesto, Marx and Friedrich Engels wrote that capitalism “cannot exist without constantly revolutionising the instruments of production, and thereby the relations of production, and with them the whole relations of soci­ety …. All fixed, fast-frozen relations, with their train of ancient and venerable prejudices and opinions, are swept away, all new-formed ones become antiquated before they can ossify." Marx did not share Smith’s view that markets are adaptive, self-organizing systems whose emergent properties are social prosperity and peace. Schumpeter followed Marx in describing markets as gyrations of upheavals rather than as marginal adjustments to equilibria.

Like Marx — and unlike Smith — Schumpeter believed that technological innovation, with its Sturm und Drang, determined the behavior of markets. In The Wealth of Nations, Adam Smith saw technological change as resulting from, rather than driving, market exchange. He thought of creativity as a by-product of the division of labor. Those who specialize are able to invent “a great number of machines which facilitate and abridge labour, and enable one man to do the work of many.” Paul Krugman, in his book Peddling Prosperity, explains that Smith and other economists saw innovation as “magical” because it is exogenous to or lies outside the scope of economic theory.⁷ This is precisely the reverse of the belief of Marx and Schumpeter, that innovation drives economic growth from the inside as the endogenous engine of capitalism.

According to Smith, markets guided by price signals are inherently self-organ­izing. Smith argued that, in a free market, the division of labor — specialization in response to comparative advantage — would produce greater and greater returns to trade. He proposed that as long as liberty and property are protected, a natural human propensity to truck, barter, and exchange would lead by itself — or through price signals — to social prosperity and peace. “Little else is requisite to carry a State to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable adminis­tration of justice; all the rest being brought about by the natural course of things.” This is the theory of the invisible hand.

Economists in the tradition of Adam Smith have made the concepts of trade, choice, and exchange central to economic theory. From this point of view, the innovator or entrepreneur takes advan­tage of differences in the costs at which goods can be supplied and differences in the prices at which they can be sold. On this account, the activity of entrepreneurs does not upset but creates equilibrium by incessantly adjusting prices to costs at the margin in order to turn a profit. According to standard theory, this profit motive is what drives the entrepreneur. As one economist has written, “A market relies on the incentive of profit to set in motion the entrepreneurial process. It is solely because of the desire to obtain profit that we can, in any degree, ‘rely’ on entrepreneurial discovery of where those profits are to be had.”⁸

Schumpeter belittled the profit motive just as he disparaged price competition as the driver of economic growth and change.⁹ He argued, “To act with confidence beyond the range of familiar beacons and to overcome that resistance requires aptitudes that are present in only a small fraction of the population and that define the entrepreneurial type as well as the entrepre­neurial function. This function does not essentially consist in either inventing anything or otherwise creating the conditions that the enterprise exploits. It consists in getting things done.”¹⁰

Many historical figures to whom we refer invidiously as robber barons or favorably as captains of industry (think John D. Rockefeller) illustrate what is involved — not all of it pleasant — in getting things done. Today, one is likely to refer to Steve Jobs to illustrate Schumpeter’s ideal of the entrepreneur as innovator and creator as distinct from inventor or profit-seeker. Walter Isaacson, the biographer of Steve Jobs, said of him, "He would do it over and over again by being passionate. Not about making a profit, because he said if you're passionate about making a profit sometimes you cut corners. But if you are passionate about making a product or service, or are passionate about what you are doing, eventually the profits will follow because you will make things of value."¹¹

Schumpeter thought of the entrepreneur not as an arbitrageur but as an aristocrat — an Übermensch in Nietzsche’s sense. According to one commentator, Schumpeter’s “glorification of capitalism centers on the heroic image of the entrepreneur; and this image, like the idea of ‘creative destruction’ itself, owes far more to Nietzsche than it does to Adam Smith. Schumpeter’s entrepreneur is a charismatic figure, whose injection of new energy rescues the capitalist system from its otherwise fatal entropic tendencies.”¹² Schumpeter took from Nietzsche the thought that “Whoever must be a creator always annihilates.”

In this way, Schumpeter believed, the innovator is motivated more by the will to power than by the wish to profit. (Of course, these are not incompatible.) According to Schumpeter, it is persistence more than science that creates and destroys. He wrote:

The inventor produces ideas, the entrepreneur ‘gets things done,’ which may but need not embody anything that is scientifically new. Moreover, an idea or scientific principle is not, by itself, of any importance for economic practice: the fact that Greek science had probably produced all that is necessary in order to construct a steam engine did not help the Greeks or Romans to build a steam engine; the fact that Leibnitz suggested the idea of the Suez Canal exerted no influence whatever on economic history for two hundred years.¹³

As this passage suggests, Schumpeter did not believe that scientific advance — what we might now call “basic research” — by itself results in the creative destruction associated with innovation. It helps, no doubt, but the essential step has to do with vision: the organization of people and knowledge in new ways to accomplish great ends. Unlike economists, who view price competition and the profit motive as inspiring and directing innovative activity, Schumpeter argued that innovation results from the passion of an individual or a team to pursue a project to realize its potential. Profits, though important, were secondary.

Although the sources of innovation remain enigmatic, military history provides some salient examples. The use of interchangeable parts is the kind of innovation that destroyed whole ways of manufacturing and created new ones in their place. It did not take a great advance in science; it only took someone’s vision to get it done. The iconic event happened in July 1801, when Eli Whitney assembled and disassembled ten guns from a mixed pile of interchangeable parts in a presentation before the United States Congress. Congress then ordered standardized parts for military equipment. The idea swept industry — creating the assembly line — later in the century.

Other military examples come to mind. President Dwight Eisenhower built the Interstate Highway System so that troops could be transferred between coasts. This system of highways has been great for trade, but it is unlikely the invisible hand could have got it done. The Defense Advanced Research Projects Agency (DARPA) is credited with extraordinary innovations, such as those that became the Internet. It’s not just that the military has money — or is not worried about making a profit — that makes it a source of innovation. More important may be that the military is itself a disruptive enterprise, where comparative advantage has more to do with surprise than with efficiency.

The theory of creative destruction implies that even entrenched firms — Microsoft would be an obvious example with its monopoly on the Windows operating system — have to keep changing, innovating, and making their most profitable products obsolete in order to survive. The fate of the video rental giant Blockbuster bears testimony to this point. The communications giant Viacom bought Blockbuster for $8.4 billion in 1994, less than a decade after it had been founded. Four years later it sold off the company for less than $500 million. Over the next 10 years, as the video rental business flailed, Blockbuster tried to catch up by imitating innovators like Netflix, but to little avail. Blockbuster filed for bankruptcy in 2010, and in 2013 it announced it would close the few of its remaining stores in the United States.

Isaacson has said that when Steve Jobs developed the iPhone his business office deplored his intention to give it the capacity to store and play music. The decision would drastically curtail sales of the iPod — then the most profitable Apple product. Jobs countered that if Apple did not make its cell phone a media hub, a start-up would combine both features in one product and leave Apple in the dust. To survive, Apple had to destroy its best-selling gadget.

Probably the most unusual aspect of Schumpeterian economic theory is its insistence that monopolies and oligopolies, far from resisting technological change, are often it best source. This is in part because they feel threatened not by direct competitors but by innovators — the way Kodak succumbed not to Fuji film but to cell phones with cameras — and in part because they have the deep pockets that allow them to invest in fantastic ideas that might work out in the long run. Microsoft has a near monopoly on operating systems and some office software, but has to make old versions seem antiquated by replacing them with better ones. Oligopolies and monopolies have both the incentive and the opportunity to make their products obsolete before someone does it for them. For Schumpeter, this made concentrated wealth an engine of technological change.

One can easily find examples — Bell Labs is perhaps the most often cited — to illustrate Schumpeter’s theory of the creative use of monopoly rents. Historically, Henry Ford and John D. Rockefeller exemplify the power of wealth to create change, as much through innovation in industrial organization and business practice as in product development. Today, one can add Microsoft, Google, Apple, Intel, and other well-funded dominant technology companies to the list of oligopolies that pursue radical innovation not only because it is fascinating for its own sake, but also because it is really the only way to survive. Andrew Grove, former CEO of Intel Corporation and author of Only the Paranoid Survive, described the investments an oligopolist is able to make — and must make — in futuristic innovation. “We all need to expose ourselves to the winds of change,” he wrote.¹⁴

Schumpeter did not think economic revolutions were constant — not every point is an inflection point, not every wind blows everything away. Over periods of time, economies will settle down to make incremental changes in existing technologies. There is still a business cycle. Technological revolutions, Schumpeter wrote, “are not strictly incessant; they occur in discrete rushes which are separated from each other by spans of comparative quiet. The process as a whole works incessantly however, in the sense that there always is either revolution or absorption of the results of revolution, both together forming what are known as business cycles.”¹⁵

Schumpeter’s view of monopoly stands that of Adam Smith and mainstream economics on its head. For Adam Smith and the economists who followed him, restraints to trade such as monopolies and oligopolies impede the functioning of the invisible hand. From this perspective, monopolists have the power and incentive to create an artificial scarcity of a good, and thus force consumers to pay more for and consume less of it than they would if competition had brought prices down closer to costs. In this Smithian view, the role of government is to break up monopolies or, where there are large returns to scale (“natural monopolies”), to regulate the prices they may charge. Schumpeter believed that monopolies are much more vulnerable to competition than is usually thought — not in terms of price competition with businesses that sell the same product, but to start-ups that would replace them by offering a completely different product that either meets the same demand or more likely creates a different kind of demand instead.

Schumpeter favored monopolies and oligopolies because they can realize economies of scale, standardize production, and take advantage of monopoly rents to invest in transformative research in science and technology. The problem for capitalism, Schumpeter thought, was not so much to manage the business cycle as to deal with the phase transition from one relatively stable condition to a very different one. “In other words, the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them.”¹⁶

It is a commonplace notion that profits are needed for investment and investment for profits. As a way out of this chicken-and-egg conundrum, Schumpeter suggested that economists think of investment as deriving in large part from a pre-competitive vision, that is, an idea that an individual or group believes will make a big difference, but has not been brought into the reach of a business plan. This argues in favor of government-funded research, as it has made and can make enormous contributions to economic growth through the pre-competitive exploration of technological possibilities. It may also support general technologies that might be used in any number of ways, as the computer is used today. General-purpose technologies seem particularly suited to public support since their economic product will be widely shared.

Governmental agencies are much more successful in exploring and demonstrating possi­bilities than in getting things done. Product development by the government — at least since the Manhattan Project — has had a dismal record, as debacles like the US military’s Joint Strike Fighter (F-35) illustrate. We may have no better way to encourage innovation publically than to support pre-competitive research in the hope that it will lead private entrepreneurs to useful projects. This is different from supposing that the government is as good an executor as it is an innovator.

There seems to be no way to know ex ante what kinds of inventions, research programs, or scientific advances will pan out the gold of innovation. The role of monopoly, oligopoly, and government in advancing innovation should be appreciated, as Schumpeter argued. At the same time, we continue to rely on firms, start-ups, venture capitalists, and other market players to place their bets; we can tell only ex post what made things happen. If we knew what causes innovation, we would not be discussing it. Whatever causes it, according Schumpeter, innovation (and its potential upheaval) is the essence of capitalism. Is this process a good thing? To this, Schumpeter replied, "The question of appraisal of social gains from entrepreneurship ... is so complex and perhaps even hopeless that I beg to excuse myself from entering into it."¹⁷