Schumpeter and Creative Destruction

Joseph A. Schumpeter, 1883 -1950, an economist of the "Austrian school of economics"; i.e. believes in small government, made a number of important contributions to twentieth century thought.  A critic of Marx and Keynes, Schumpeter developed a sophisticated perspective for thinking about business cycles, political institutions, and social processes in the modern world.  Among his most important economic studies are The Theory of Economic Development and Business Cycles.

Capitalism, Socialism, and Democracy is a penetrating inquiry into the nature and future of capitalism, and its relationship to socialism and democracy.  A History of Economic Analysis remains unrivaled as a study in the history of economic ideas.

The 4 Phases of Creative Destruction

Schumpeter codified a long wave concept (we''ll discuss long waves in the near future) of economics known as Creative Destruction which is broken into 4 distinct phases. This Creative Destruction has been bantered around for several years by economists and media personalities as an explanation for the creation of Internet and technology stocks and the link between them and the increase in productivity over the past decade.  And, that is OK and probably accurate. The problem is that this only correlates to phase 1, "Prosperity", of Schumpeter's 4 phases of Creative Destruction.  If you believe in the probability of phase 1 it is imperative to understand the other 3 phases that follow it.  I will explain them very briefly here.  Beyond this though I want you to be critical of the information you hear presented.  The argument as it has been presented by the media, selective disclosure and non-disclosure, affords the knowledgeable listener to discern only one of two conclusions; 1) the media personality introducing the concept did not know they were misrepresenting the concept, or 2) they did.

Phase 1 - Prosperity

Economic evolution begins when an exceptional entrepreneur, "the conductor", introduces an innovation. This enables the individual to make monopolistic profits and stimulates the borrowing of capital in order to increase the investment.  The activity of the first entrepreneur also smoothes the path for other entrepreneurs to introduce innovations in associated or related fields.  This "swarming of entrepreneurs" is financed through credit creation, which Schumpeter calls, "the monetary complement of innovation." Credit permits these firms to ''bid away'' factors of production from older non-innovating firms. This produces a rise in prices and a general economic expansion. This describes globalization of the last 2 decades.

Phase 2 - Recession

Prosperity peaks, i.e., reaches its upper turning point, for several reasons I won''t address here.  Unable to compete with successful new firms, older non-innovating firms and unsuccessful new firms suffer losses. New investments are halted because the economy is disrupted and it becomes impossible to make reliable calculations about the future. The possibilities offered by the current cluster of  innovations are exhausted; and Interest rates rise, as in FED policy pre-2000.  (This gets to Greenspans contention that the productivity enhancements offered by existing technology have not been maximized as of yet and will allow for a postponement of this phase or an extension of its period.)   The subsequent downturn causes recession.

Phase 3 - Depression

The decline of Recession continues however, past equilibrium in a secondary wave which Schumpeter attributes to "errors, excess of optimism and pessimism. ...  "Reckless, fraudulent and otherwise unsuccessful enterprises created in the optimism of expansion cannot stand the test administered by Recession". They are liquidated. These liquidation''s, in turn, undermine the debt structure which begins to "crumble" and this causes a "panic." Deposits shrink and credit tightens even further. Firms which would have been able to withstand the contraction had it not resulted in panic are liquidated in what Schumpeter calls ''abnormal'' liquidation''s and among other enterprises there is "a shrinkage of operations that reduces them, quite erratically, below their equilibrium levels". This is essentially a description of the Asian financial crisis that began in July 1997 and that since has spread its "contagion" through Russia, Brazil, Argentina.  It is probable that this is the phase Japan is in the middle of now and that which the EU and the US are transitioning towards.   This transition from phase 2 to phase 3 can take a decade or more.  I believe that this may be what both Warren Buffet and Sir John Templeton may be expecting for the next decade in the US.

Phase 4 - Revival

Depression continues until all unsuccessful and excess investments are liquidated. Once this point is reached, a movement towards a new "neighborhood of equilibrium" is initiated; revival. Schumpeter emphasizes that every cycle is "a historical individual and not merely an arbitrary unit created by the observer".  The revival and return to phase one requires opportunity to be afforded somewhere for the next entrepreneur and as such can not be predetermined.