Schumpeter on Economic Evolution

No attempt is made here to survey in depth Schumpeter's work on business cycles. Fels (1964) provides a short summary and cites references to other surveys, and innovatory assessments of Schumpeter's work continue to be produced. Instead, a brief sketch of the essentials will be provided to form a background to subsequent sections of this chapter. Schumpeter (1934, Ch. II) distils the essential features of his theory of capitalist economic development and explains why innovations might be expected to occur in 'swarms'. This theory is embellished in Schumpeter (1934, Ch. VI) in an attempt to explain the Juglar, or business cycle, rather than minor, or Kitchen cycles and long, or Kondratieff waves. The embellishment includes discussion of secondary expansionary waves, which spread as a result of the burst of innovatory investment that sets the cycle in motion. Schumpeter (1939, Chs. III and IV) reconsiders the previous analysis and presents three approximations to a theory of the business cycle.

The first approximation is a two-phase cycle which is the result of stripping the Schumpeter (1934, Ch. VI) model back to basics, by ignoring the secondary wave of expansion and developing the ideas of Schumpeter (1934, Ch. II) to explain the fundamental cause of capitalism's cyclical evolution. The second approximation involves the examination of the effects of introducing the secondary wave of expansion and consists of a four-phase cycle in which financial crises and depressions become possibilities. Concluding his analysis of the secondary approximation, Schumpeter acknowledges that due to their historical uniqueness, observed cycles will be irregular in period and amplitude. The third approximation postulates that the process of evolution may well give rise to more than one wavelike motion. A three-cycle schema is adopted to facilitate theoretical, statistical and historical analysis of cycles of various lengths. The basic idea is, however, that innovations may vary in importance and that the more important they are the longer the periods of gestation and absorption are likely to be. This reflects a relaxing of the assumption that swarms of innovatory investment can only occur once the economy has completed its adjustment to a new equilibrium following a previous burst of innovatory investment.

Schumpeter (1939, Ch. VI) concludes his theoretical analysis by considering the impact and causes of external shocks and special cycles, such as agricultural and 'hog' cycles. He argues that external shocks elicit a responsive adaptation from the economy which is fundamentally different from the evolutionary adaptation that results from internal shocks caused by bursts of innovatory investment.

Schumpeter therefore aims to describe both why the economy evolves cyclically, rather than evenly, and why business, and perhaps other longer and shorter cycles, take their observed form. His first approximation attempts to identify the fundamental cause and nature of dynamic economic development or evolution. His second and third approximations, and the discussion of 'other fluctuations', attempt to explain the observed business and other cycles and reconcile them with alternative theories of the business cycle. The latter tend, in his view, to concentrate on secondary aspects rather than on the primary cause of fluctuations, which is the bunching of innovatory investment.

The proposition that the bunching of innovatory investment is the primary cause of the cyclical development of capitalism is utilised by Shackle (1938), whose contribution (discussed in section 4.4) was to employ Keynesian and Myrdallian insights to develop Schumpeter's analysis of the secondary wave of expansion. Goodwin, like many other economists, remains unconvinced by Schumpeter's explanation ofbunching1' and prefers to explain the apparent bunching of innovatory investment as a rapid secondary response, illustrated using his multi-sectoral input-output approach, involving what Schumpeter would call induced investment and multiplier-accelerator interaction. Shackle's explanation of the bunching is weak and it appears to be used as a deus ex machina. Fels (1964) notes that the clustering of innovations in Schumpeter's analysis is not due to the rarity of innovatory genius per se. Instead it is a reflection of the fact that innovation is difficult. Untried combinations must be tested and financiers must be persuaded to back the potential new ventures. Not all will get finance and few of those that do will be successful. Once a breakthrough is made, however, other entrepreneurs will copy or improve upon it and the credibility of ventures, in the eyes of banks, will increase. Induced innovatory investment will occur, resulting in clustering.

The point of departure for Schumpeter's theory of economic development is an equilibrium state in which there may be growth but no evolution, in the sense that no new products are coming on to the markets and no new methods of production are being tried. The underlying cause of growth in equilibrium is not analysed in depth but is attributed to population growth among other things. The equilibrium is then disturbed by an internal shock in the form of a swarm of new entrepreneurs successfully introducing a cluster of innovations. The result is a bunching of innovatory investment. Even in the absence of secondary effects a new equilibrium must be sought, for which factors of production must be redeployed. The banks are assumed to be the main source of finance for the 'new combinations'. They are seen as venture capitalists which sponsor new combinations, rather than as broking intermediaries. They play a key role by expanding credit and creating new purchasing power to meet the additional demands of the new enterprises. In the first approximation, the entrepreneurial function is completely separated from the capitalist function, which is performed by banks. Entrepreneurs are not capitalists; they are innovators who draw on the stock of new possibilities being offered as a result of additions to the stock of knowledge resulting from inventions and other discoveries. Clearly, in a modern financial system entrepreneurs often need to look to specialist venture capitalists, rather than banks, for start-up and development capital.

The swarm-like appearance of entrepreneurs necessitates a special and distinctive process of absorption, which involves incorporating new products and technologies and adapting systems to them, and also a process of liquidation of outmoded enterprises, which must make way for the new. This process is the essence of Schumpeter's recessions, in which the economy struggles towards a new equilibrium.

The disturbance, to which old enterprises must react, manifests itself in various ways. As the new enterprises bid for means of production, their price is bid up and this raises the cost of the old enterprises. As the new products enter the market to compete with old ones, the old enterprises face a fall in demand for their products and a decline in revenue. The seeds of recession are sown. The length of time between the formation of new enterprises and the appearance of new products, also en masse, is a fundamental determinant of the length of the boom in Schumpeter's model. As new enterprises begin to receive revenue, they begin to extinguish debts, and the purchasing power created by banks begins to disappear. The reduced profitability of the old enterprises and the increased uncertainty that follows rapid change will make banks wary about diverting credit to old enterprises. The new enterprises enter a highly competitive environment with differentiated products and earn monopoly profit for a period, but it is gradually eroded by competition.

Eventually the period of prosperity gives way to a recession. Businessmen must learn to adapt to the new situation in which new competitors have become established, old customers and lines of credit cannot be relied upon, and production levels must be adjusted to prevent the accumulation of stocks of commodities that have become more difficult to sell. Schumpeter therefore regards the recession as a process of adjustment and 'resorption'. Old businesses must adjust and new ones must survive their first test. The next boom cannot start until the adjustment is nearly complete and a new equilibrium is approached. This is because the high level of uncertainty that is present while adjustment is taking place discourages new investment. Given the assumed separation of the entrepreneurial and capitalist functions, this must be due to the unwillingness of banks to lend.

The fundamental process of economic development described above is embellished in Schumpeter (1934, Ch. VI and 1939, Ch. IV) by the introduction of a secondary wave of expansion. The banking sector also plays a key role in the financing of the secondary wave, which is based on a sort of multiplier-accelerator expansion. As a result of the secondary wave, excesses can occur and there is likely to be significant overshooting of the new equilibrium. Financial crises can occur as a consequence and the ensuing recession can develop into a depression if overshooting in the downward direction results. A problem of explaining the lower turning point then arises and Schumpeter argues that government economic policy should aim to terminate depressions because, unlike recessions which entail a movement towards a new equilibrium, they serve no useful purpose. Policy-makers are not told, however, how to identify the point at which recession turns into depression and the new equilibrium is overshot. Once terminated, the depression gives way to a recovery or revival, which is also a motion towards equilibrium. The new equilibrium is unstable in an upward direction and following another burst of innovatory investment, a new expansionary phase, with its primary and secondary waves, begins. The depression phase, it is argued, is not a necessary part of economic development but may feature in some business cycles and so too might financial crises. Institutional reform and macroeconomic policy should, therefore, concentrate on the elimination of depressions and financial crises, but it should be accepted that cyclical evolution is the norm for capitalist economies. By deciding which innovations to sponsor and, in pursuit of profit, allocating capital as efficiently as they can, banks in capitalist economies essentially play the role that the planning agency plays in centrally planned economies.

Each cycle, Schumpeter argues, is a historical individual in the sense that it will depend on the nature of the particular innovations that provide the initial shock starting the cycle and the prevailing structure of the economy and the financial system. These factors are in turn clearly influenced by the evolution that has preceded the cycle in question. Given the uniqueness of each cycle, there is no need to expect regularity of period or amplitude (see section 1.2). Further, Schumpeter argues in his third approximation, there is no reason to expect that the cyclical evolution will consist of only one wavelike motion because innovations have different periods of gestation and absorption. It is more likely, he concludes, that there is a multiplicity of cycles which may or may not be related in some way.

The internal shocks caused by the bunching of innovatory investment, Schumpeter argues, give rise to a primary tendency to cyclical evolution, which is the manifestation of the economy's adjustment to these shocks and which Schumpeter calls economic development. Because of the diverse nature of the shocks, the primary cycles can vary in period and amplitude. The capitalist economic system is organised in such a way that these internal shocks are likely to be amplified by secondary waves of expansion which give rise to the possibility of financial crises and depressions. The government's role should be to regulate the capitalist system to prevent excesses leading to crises and to utilise monetary and fiscal policy to attenuate depressions. The economic system is also hit by external shocks which will themselves create a need for economic adjustment. This is not regarded by Schumpeter as being part of the development process, but it will clearly add to the irregularity of cycles and assure their historical uniqueness. The shocks are also likely to add to the amplitude of cycles in the way that the secondary waves of expansion and other factors, discussed in Schumpeter (1939, Ch. IV), are assumed to do. Before a discussion of the related work of Shackle (1938), the next section will consider the hypothesis that there are longer cycles than the business cycle, and related issues.

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