From Statics to Dynamics: The Cycle

In the 1908 book, Schumpeter followed the marginalist tradition, according to which the value of economic goods is expressed by demand for them relative to their scarcity. However, he rejected Jevons’s utilitarianism, based on the identification of value with the (subjective) measure of the ability of goods to satisfy such needs. In fact, ‘psychological deduction is simply a tautology. If we say that somebody is prepared to pay something more than somebody else because he values it more, with this we do not give an explanation, since it is precisely from his evaluation that we infer the fact that he offers to pay a higher price’ (ibid., p. 64). As a consequence, the so-called principle of decreasing marginal utility according to Schumpeter ‘in economics ... is not a law ... but a basic assumption for the generalisation of given scientific facts. As such this assumption is in principle arbitrary’ (ibid., p. 71). Similarly, ‘the homo oeconomicus - the hedonistic computer - ... is a construction the hypothetical character of which is now known’ (ibid., pp. 80-81).

Schumpeter considered the theory of prices to be ‘the core of pure economics’ (ibid., p. 106). His illustration of this theory was not without defects and did not offer novel analytical contributions. What is interesting, rather, is the interpretation he gave of this theory. In his opinion, the point of arrival of the theory of economic equilibrium is what he called ‘the method of variations’. In fact, ‘we can never explain an actual state of equilibrium of the economy’ (ibid., p. 361) but only what consequences change in one of the data has on equilibrium: ‘This is the only reason for which such laws have been constructed’ (ibid., p. 360). Such a method - what is nowadays called comparative statics analysis - may be used only in a very limited ambit, with respect to infinitesimal changes: ‘rigorously speaking, our system excludes any change whatsoever’ (ibid., p. 375). However, the economic equilibrium approach is useful because with it light can be shed on a particular aspect of economic realities subject to continuous change: habit, repetitiveness, the myriad of ‘mechanical’ actions of everyday life.

The main point of differentiation between Schumpeter and traditional marginalist theory concerned the theory of interest. Schumpeter criticised the theory developed by his professor Bohm-Bawerk, who ‘defines interest as the premium of present goods over future goods’ (ibid., p. 329), and opposed this theory with a different, ‘dynamic’ approach: ‘The essential phenomenon is the interest deriving from credit which serves for the creation of new industries, new forms of organisation, new techniques, new consumption goods’ (ibid., p. 355). In the static system, according to Schumpeter, the money market plays only a secondary, passive role, while it becomes an active player only within the process of economic development.

This thesis was developed in the Theory of Economic Development. The first edition of this famous work - a massive volume in German, prolix and rich in disquisitions on historiography and methodology - was published in 1912, with a second edition in 1926; its popularity is mainly due to the much shortened English edition, published in 1934.

The dichotomy between statics and dynamics was substituted in this work with a dichotomy between theory of the circular flow and theory of development. The circular flow corresponds to the stationary state, in which the economy reproduces itself, period after period, without structural change; Schumpeter also admitted in this context a purely quantitative growth, from which changes in production technologies and consumers’ tastes were excluded by definition.

Development, by contrast, is characterised by change. The role of active agent in the process of change is attributed to the producer, while consumers follow passively and ‘are educated by him if necessary’ (Schumpeter 1912, p. 65). Having recalled that ‘to produce means to combine materials and forces within our reach’ (ibid.), Schumpeter noted that ‘development in our sense is then defined by the carrying out of new combinations’ (ibid., p. 66), namely ‘the introduction of a new good’, ‘the introduction of a new method of production’, ‘the opening of a new market’, ‘the conquest of a new source of supply of raw materials or half- manufactured goods’ and ‘the carrying out of the new organisation of any industry, like the creation of a monopoly position ... or the breaking up of a monopoly position’ (ibid.).

The introduction of new productive combinations is the work of the entrepreneurs, who are such only insofar as they make innovative choices. That of the entrepreneur is a key category: as the originator of change, the entrepreneur generates capitalistic development (while within the classical economists’ approach it is the process of development that generates the drive to change); his motivation is not that of the homo oecono- micus but rather ‘the dream and the will to found a private kingdom ... the will to conquer ... the joy of creating, of getting things done, or simply of exercising one’s energy and ingenuity’ (ibid., p. 93).

Alongside the entrepreneur in the process of development Schumpeter extolled the role of the banker, considered equally necessary. This thesis stemmed from two crucial assumptions in the Schumpeterian model. In conformity to traditional marginalist theory, to which Schumpeter adhered, in equilibrium there are no unused resources on which entrepreneur-innovators can rely. Thus entrepreneurs can accomplish their innovations only if they have at their disposal some ad hoc purchasing power with which they are able to draw the resources required to start new productive processes from ‘old’ firms (that is, from the set of traditional productive activities) and from consumers. Such purchasing power is created ex novo by the banks: thus, the innovative and executive capacity of entrepreneurs needs to be accompanied by the far-sightedness and ability of the bankers to evaluate aright the potentialities of new initiatives. Bankers too, like entrepreneurs, have to accept the challenge of uncertainty (and the consequent risks of losses and failures) that accompanies anything that is new.

Entrepreneurs set on innovation apply to bankers who, if they decide to finance the innovation, agree to the loan and thus create the means of payment with which entrepreneurs can enter the markets for productive resources. By assumption, in equilibrium all available productive resources are already utilised; as a consequence, the additional demand cannot be satisfied by an increase in supply. Thus, there is an increase in prices, which automatically reduces the purchasing power of consumers and traditional firms. The inflationary process allows new firms, financed by banks with newly created means of payment, to draw productive resources from their traditional uses. This is a theory of forced saving: an element common to various theories developed within the Austrian school and connected to the idea that the economy tends to full employment. (Monetarist theories maintaining that private investments are crowded out by public expenditure, developed in the 1950s and 1960s as a reaction to Keynesian policies, are but variants of the theory of forced saving.)

The trade cycle is linked to the process of development. The phases of expansion take place when the innovation is imitated by a swarm of new firms attracted by the temporary profits realised by the entrepreneur- innovator. The phases of recession arrive when repayment of the loans provokes credit deflation; furthermore, if firms are able to pay back the banks, it is thanks to sale on the market of products obtained with new technologies, but this exerts a downward pressure on the demand for, and prices of, the old products, which leads to bankruptcy for firms that have remained anchored to old production technologies, and especially those most directly hit by competition from the new products; thus, those who fail to keep pace by adapting to the innovations are expelled from the market.

If innovations were uniformly distributed over time, taking place now in one sector of the economy, now in another, the phases of expansion and recession would concern different sectors in different periods of time, while on average development would follow a regular path for the economy as a whole. However, according to Schumpeter the development process is discontinuous. In fact, innovation implies a break in the traditional way of proceeding: in other words, the barriers represented by the force of tradition must be overcome in order to implement the innovative change, and such barriers are easier to overcome the more widespread the change is within the economy. Thus innovations do not constitute a regular flow over time but appear as grouped in swarms. Schumpeter’s trade cycle theory, like Marx’s, is thus characterised by the endogenous nature - that is, internal to the theory - of the relationship between cycle and development. Within both theories, the situation at the end of a cycle must be different from the situation at the beginning because of technological change, which plays an essential part in the cyclical movement of the economy.

The basic model of development theory presented in the 1912 book did not change in substance in the ponderous work on Business Cycles (1939) but was further developed with analysis of market forms other than perfect competition, the simultaneous presence of short, long and very long cycles, the fifty-year cycle having to do with epoch-making innovations that affect the whole of the productive system such as railways, with the transport revolution, electricity, or information technology in our own times.

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