4. Schumpeter

The author believes that he had already mentioned often enough that biographical informations can be found on wikipedia, about Joseph Schumpeter for instance here, Joseph Schumpeter. There is therefore no need to tell the live of Joseph Schumpeter here.

For reasons already mentioned several times, see methodological approach, neoclassical theory, that's what we found in modern textbook, is almost exclusively about equilibriums. The analysis focus on the characteristics of the equilibrium, but not attention is paid to the question how to get there, the actually interesting question.

Schumpeter is the most prominent critics of this concept, also he assign "static thinking" to the classical theory, especially Adam Smith, and it can be cuestioned that Adam Smith is a static theory. The champions of the static theory are Vilfredo Pareto and Léon Walras.

Modern textbooks about microeconomics are a simplified version of ecclecticly chosen concepts of Alfred Marshall. Concerning Vilfredo Pareto simplification and a ecclectlical choice is mercy, because if we read the original version, we can get to the conclusion that Vilfredo Pareto was just mad.

We find in modern textbooks three different types, with different scopes, usability and meaning. The most important one is the partial equilibrium of Alfred Marshall. If we know what we are doing, if we take into account that the marshallian cross of the supply curve and the demande curve is a short run analysis, something Alfred Marshall was well aware of, see cardinal measurment of utility, we can analyse with these instruments the effects of taxes, customer duties, mininal prices, maximal prices, a change in the preferences etc.. It is also a handy method to illustrate that in the equilibrium the public wealth is maximised, at the equilibrium the consumer surplus and the producer surplus reaches its maximum. Partial equilibriium means, that only one product is considered.

The general equilibrium was first described by Adam Smith, see natural price / market price. The general equilibrium describes the "natural" result of a market economy. It is obvious, at least as a tendency, that any resource will be reallocated if its use is more profitable in another use and no further reallocation will happen, if the profit or wage is the same everywhere. In order for a market economy to work it is not necessary that this state is actually reached, it will never be reached. It is enough that there is a tendency towards this state.

From this general equilibrium there is a second version, the version of Léon Walras. Superficially Léon Walras states the same thing as Adam Smith, however his argumentation is wrong. His analysis is based on a market where products are only exchanged, but not produced. In other words, the amount is fixed. (What is the same as to say that his analysis is only true in the very short run under special conditions, for instance that the market is cleared at the end of the period.) If the amount is fixed, there can only be a change in the prices, but not in the amount and what is still more strange, concerning the productive factors, he assumes the exact opposite. The price, for instance the wage, is fixed and the amount changes. We all know that in reality there is always an adaptation of the prices AND the amount.

The last equilibrium is the equilibrium of Vilfredo Pareto. Vilfredo Pareto wanted to circumvent the problem related to the cardinal measurement of utilitiy. Not really a problem from a practical point of view, however it is true that the fact that two people spend the same amount of money for a commodity doesn't mean that the utilitiy is the same for both, because the utility of money depends on the amount someone possesses of it. The more he have, the lower the utilitiy of the last unit.

In a very hypothecial framework, the Edgeworth Box, Pareto shows that people will change goods for goods, as long as both of them profit from that change or at least none of them is worth off after the change. This is a lot of effort for very little insight. Eliminating this equilibrium from textbooks about microeconomics and stop teaching it wouldn't be a big loss. At the other said with the time saved a lot of useful things can be done.

Schumpeter saw very clearly, that all these three models describes static economies, economies that doesn't grow. He didn't analyse this phenomenon in detail, he didn't mention that the analysing of equilibriums leads to a dramatic reduction of complexity and leads to result which are almost irrelevant, see methodological approach, and he didn't give any reason why economics focuses on equilibriums, but he saw clearly that not the equilibrium is the relevant issue, but the process that leads to equilibrium.

A static economy is an economy where year after year the same products are produced in the same amount with the same methods.

However his distinction between a quantitative change and a qualitative change is less convincing. A cuantitative change means that the same products are produced with the same methods, but the amount increases. This is actually not possible in the logic of Schumpeter, because that would required that some resources are not used, but Schumpeter assumes full employement.

If full employement is assumed an increase in national income is only possible if the resources are used in a more efficient way, in other words, if there is an improvement in the economic structure.

Concerning the changes of the economic structure Joseph Schumpeter focuses completely on the creative destruction triggered by a charismatic entrepreneur. He abstracts completely from technological, social, economic circumstances and the entrepreneur is not described as the result of psychological process influenced by the these circumstances. Entreneurship is determined genetically.

This is theoretically not very plausible and practically useless. In economies where "capital" in the sense of machines, building, raw materials becomes more and more irrelevant and know how more and more relevant, the ability to cooperate is crucial and that requires entrepreneurial skills. The question is therefore how to improve them and the statement that this skills are genetically determined is of no help.

Joseph Schumpeter is celebrated because he realised some actually simple things, which for normal people are not very surprising, but are very surprising for academic economists who have been teaching microeconomics for ten years. After ten years they have lost any contact to reality.

  1. No economy will remain in the equilibrium. Preferences changes, the qualification changes, the size of the market changes, the organisation changes etc. etc. At the long run almost everything changes.
  2. Changes are triggered by human decision making and this decision making process is far more complex than an adaptation of the amount to a change of prices. The adaptation to a change of prices can be done by any robot, for this no human decision making is needed.
  3. The economy is the result of human decisions.
  4. The crucial point: Institutional investors like banks don't depend on prior saving to grant credits.

For the common sense this is nothing really stunning. People who are not living in the jungle or are public employees at faculty of economics are well aware that every few years things change. Academic economists are happy if there is no difference between one equilibrium and another, they analyse the same way equilibriums in Kongo and in France, in Spain and in Peru, in the United States and South Africa and they have no interest in analysing the processes that leads to very different equlibriums. They get universal valid trivialities, which they call "economic laws".

The economic laws found by Vilfredo Pareto are so trivial, that the are valid even on Mars. We don't know if someone is living there, but if it is the case, they will only become trading partners if both of them benefits from trade or at least none of them is worse off after the trade. This is so trivial, that it is true.

In the neoclassical theory and at a certain degree in the classical theory as well, especially in ricardian system, economic development is determined by the "forces of the markt". This forces of the market are something like the gravitation force or magnetism and will be valid even if the earth flies soulless through the universe. In neoclassical theory there is no need for human decision making. Labour and capital moves alone to the most profitable use. Any robot can do that and much better.

To put it short: Schumpeter discovered the subject in the economic universe. We don't say that this is a big discovery, almost anybody besides academic economists already knew that something like that exists, but for academic economists this is a very big discovery and still today they doubt that something like that really exists.

The discovery that institutional investors like banks don't depend on prior savings for granting credits one could had imagined as well. If someone knows that the credit granted to him by a bank can come from the central bank as well, who just prints it, it is crystal clear that no prior savings are needed. For a more detailed discussion see the little book downloadable from the startsite of this website or interest rates.

However he didn't succeed in developping a full-fledged monetary theory. In order to get a full-fledged monetary theory it distinction is to be made between a situation of unemployment and situation of full employment. In a situation of full employment savings in the classical sense of the term, not consumed income of the past, is actually needed and to raise savings we need a raise of the interest rates. Savings, this is the only right definition, means less production of consumer goods in favour of capital goods. In a situation of full employment that is needed, because in this situation there is a trade off between the production of consumer goods and the production of capital goods. That is what Keynes calls the classical scenario.

In a situation of underemployment, we understand under underemployment a real potential for producing goods where a real demand exists, underemployment alone doesn't mean that the resources can be used in a profitable way, there is no need for savings, because there is no need to reduce the production of consumer goods, but high interest rates can be a hindrance for investments with a low profitability and normally unemployed resources have a low profitability.

In reality institutional investors don't invest in risky investments like the one Joseph Schumpeter has in mind in other words investments in innovations able to change profoundly the economic structure, but where are no concrete data allowing to predict the probalitiy for success. Institutional investors prefer financial assets and speculation. These kind of investements are perhaps as risky as the schumpeterian investments, but there are more liquid, in other words the investment, for instance stocks, can be reconverted in money. That is what Keynes calls preference for liquidity. We will talk about this issue in the chapter about Keynes.

The minimal condition for an investment financed with "generated" money is that the credit is paid off during his lifetime. There is no doubt that it is a bad idea to construct a house that can be used for 100 years but 120 years are needed to pay off the credit. In this case, if there are no other means to pay back the credit, part of the extra money will eternally circulate because it will never be eliminated again.

In a stationnary economy there is no need for an increase of the amount of money. The savings will derive from prior investments and will be used to substitute old machines for new ones. Banks can trigger a reduction of consumer goods in favour of producer goods by raising the interest rates. This will lead to an increase of savings and less consumption. If this is a good idea in a situation of unemployement, is another question. They will do that if the central banks restricts the amount of money available.

If the central bank follows a policy of easy money there is no trade off between financing old investments and new investments the interest rate can be the same or even lower. Provided that the innovation of the charismatic entrepreneur in the schumpeterian sense is more profitable, he can attract the resources anyway, because he can pay higher prices, for instance higher wages.

We read very often that the interest rates have an impact on the allocation of resources. This is actually not true. Not at all. This is only true concerning the trade off between the production of consumer goods and the production of capital goods in a situation of full employment. Only in this sense the interest rate has an impact on allocation.

Schumpeter didn't really understand the complexity of the problem, but he understood that a credit is "extra purchasing power", that the entrepreneur gets access to resources before he had actually "earned" them. What he wants to say is this. In the classical theory the entrepreneur gets access to "purchase power", because he had earned this "purchase power" in the past. With a credit he gets purchase power without having earned it before.

[The theory that earned "purchase power" guarentees "purchase power" in the future is by the way wrong and an error of thinking we find very often in debates about pensions. There are people who believe that pensions are granted if the rely on a "capital stock", purchase power of the past. That is in no way the case. People can only live from what is produced in the present and if in the present it is not possible to produce enough, what can happen if there are more and more pensioners and less and less people working, their capital stock is useless.]

In diesem Sinne definieren wir also den innersten Kern des Kreditphänomens in der folgenden Weise: Kredit ist wesentlich Kaufkraftschaffung zum Zwecke ihrer Überlassung an den Unternehmer, nicht aber einfach Überlassung von vorhandener Kaufkraft - von Bescheinigungen über vorhandene Produkte - an ihn. Die Kaufkraftschaffung charakterisiert prinzipiell die Methode, nach der sich die wirtschaftliche Entwicklungen der nicht geschlossenen Volkswirtschaft durchsetzt. Durch den Kredit wird den Unternehmern der Zutritt zum volkswirtschaftlichen Güterstrom eröffnet, ehe sie den normalen Zuspruch darauf erworben haben. Es ersetzt gleichsam eine Fiktion dieses Anspruchs temporär diesen Anspruch selbst. Die Kreditgewährung in diesem Sinne wirkt wie ein Befehlen die Volkswirtschaft, sich den den Zwecken des Unternehmers zu fügen, wie eine Anweisung auf die Güter, die er braucht, wie ein Anvertrauen von Produktivkräften. 

Joseph Schumpeter, Theorie der wirtschaftlichen Entwicklung, Drittes Kapitel, Kredit und Kapital

In this sense we define the heart of the credit phenomenon in the following way: Credit is essentially the creation of purchasing power put at the disposition of entrepreneurs, but not simply already existing purchasing power, the certification of already existing products. The creation of purchasing power characterises principally the method by which the economic development of a not closed economy is imposed. Through a credit the entrepreneur gets access to the production of the economy before he got a normal access to it. He substitutes somehow the pretension to this access by a fiction of this process. The granting of a credit in this sense is like a command to the economy to obey to the entrepreneur, like providing access to the production he needs, like entrusting him with economic resources.

The paragraph contains a lot of gossip (...The granting of a credit in this sense is like a command to the economy to obey to the entrepreneur, like providing access to the production he needs, like entrusting him with economic resources...) which is typical for this time.

What he wants to say is relatively simple. In the classical theory the "capitalist" can only invest with "capital", actually money, already earned (...Certification of already existing products...). A credit is different. The credit is not the result of prior savings and therefore the schumpeterian entrepreneur gets access to resources without having saved money before.

In the next paragraph we will see that this credit is an increase of "purchase power", as Schumpeter named it. We will see in the next chapter that the classical theory is always wrong, not only under the assumed special conditions of Joseph Schumpeter. If there is no DECREASE of prices, the national income can only increase if the amount of money increases, but FIRST we need an increase in the amount of money and THEN the national income increases.

For logical reasons it can't work the other way round, unless the prices don't decrease. A decrease in prices means that less money is needed for transactional purposes, the use of money a a means of payment, to keep it simple. If from a given amount of money less money is needed for transactional purposes, more money is avalaible for investive purposes, that's obvious. However prices almost never decrease and therefore an increase of the national income is only possible if the amount of money increases.

What can actually happen is the situation addressed by the keynesian theory. It is possible, unless the classic theory affirms the opposite, that some money is not used at all. Classical theory assumes, that it is "irrational" to keep money "under the pillow". If there is a preference for consumption in the present, in case of low interest rates people will consume their money, in case of higher interest rates, they will make it disposable for investive purposes in order to consume more in the future.

However, in the keynesian theory there is a third possibility. Liquid assets like stocks, bonds etc.. If a real investment is as risky as a financial / speculative investment, investors, especially institutional investors, will invest in speculations, for instance on the stock market. These kind of investments contributes almost nothing to the growth of social income, but is convenient for these investors.

These few annotations are enough to see that the Schumpeter didn't conceived a money theory. He only realised for the first time, that money can be created, see paragraph below.

However he still sticks completely to the classical theory and to fundamental concepts of classical theory, for instance that full employment is always given. Under this assumption he couldn't get to a full fledged monetary theory, because a full-fledged monetary theory has to distinguish between a situation of underemployment and full employment. Only if we distinguish between these very different situations, we can obtain useful definitions of savings and interest rates.

The style of his writings is somehow strange, but he had the same problem as Adam Smith. Adam Smith already realised, see balance of payment, that banks can create money, or even merchants can do that by issuing drafts and bills of exchange, but he didn't realised that this overthrows the classical concepts about money, savings, interest rates and capital. For a more detailed discussion see interest rates.

Die konkrete äußere Form der Kreditzahlungsmittel ist ganz gleichgültig. Am deutlichsten sieht man die Sache allerdings bei der ungedeckten Banknote. Aber auch ein Wechsel, der nicht vorhandenes Geld ersetzt und sich nicht auf bereits produzierte Waren stützt, hat denselben Charakter immer dann, wenn er zirkuliert und nicht etwa bloß die Verpflichtung des Unternehmers gegenüber seinem Geldgeber fixiert, wobei er nur eine Bestätigung sonstiger überlassener Kaufkraft darstellt. Und alle anderen Formen der Kreditzahlungsmittel bis zur einfachen Gutschrift in den Büchern einer Bank lassen sich unter demselben Gesichtswinkel betrachten. Immer treten sie neben die vorhandene Kaufkraft. Wie wenn ein Gas in ein Gefäß eintrömt, in dem sich vorher eine bestimmte Gasmenge im Gleichgewichte befand, so dass alle Moleküle gleiche Teile des Raumes einnahmen, die Anteile dieser Moleküle am Raume nun beschränkt werden, so wird das eintrömen der neuen Kaufkraft in den Raum der Volkswirtschaft die alte Kaufkraft komprimieren. Haben sich die dadurch notwendig gewordenen Preisveränderungen vollzogen, dann entsprechen den neuen Kaufkrafteinheiten gerade so gut irgendwelche Güter wie die alten, nur dass die jetzt vorhandenen Kaufkrafteinheiten alle geringeren Inhalts sind als die, welche früher vorhanden waren, und dass sich ihre Verteilung unter die Einzelwirtschaften verschoben hat.

Joseph Schumpeter, Theorie der wirtschaftlichen Entwicklung, Drittes Kapitel, Kredit und Kapital

The concrete outward form how the credit is granted is completely irrelevant. The most easy way to see that is by an unbacked banknote [in the time of Joseph Shumpeter money was "backed" by gold]. A draft or a bill of exchange, that doesn't only substitute money or refers to products already produced, has the same character, if it circulates and doesn't present a simple obligation of the entrepreneur towards the borrower. In this case it is only a confirmation of "purchase power". All kind of credits, included the credits in the books of a bank can be considered under the same perspective. They always present purchase power added to the already existing one. The same way as a gas that influx in a container, where the amount of gas was in equilibrium before, so that all the molecules occupied the same space, the molecules will now be compressed. The same thing will happen with the new purchasing power. The influx of the new purchasing power in the economy will compress the old purchasing power. Once the necessary relationships of prices are realised the new units of purchase power correspond the same way to goods as the old ones, but the new units of purchase power are inferior in value compared to the existing ones before and the distribution among the different sectors of the economy has changed.

What he wants to say is simple and he sticks to the quantity theory of money, that he combines with allocation issues in a imprecise way. The new element is the ability of the economy to generate money. It is indeed true that the economy has the ability to create money and that is well known since the Renaissance and the italian merchants. If a recognized institution, company or even individuals issues a paper saying that in case that the bearer of the paper cannot comply with his obligation they will pay instead this paper has the same value as money. The institution who issues the paper can ask some interest from the bearer to cover the risk. If they do that with a lot of people, they get an average risk for which they can insure itself. A draft or a exchange bill is something similar, although more regulated by a juridical framework.

In the history of mankind the amount of money was never, never, never fixed. It was always possibly to extend the amount of money. (And there are several methods to increase the amount of money, by the way. In the 16th century money was "backed" by gold and silver, that at least is what people in that time thought. However there was tendency to substitute gold and silber with other metalls and the share of gold and silver of a coin becomes smaller and smaller until at the end it was zero.)

But an increase in the amount of money didn't lead always to inflation, as the quantity theory of money states. It was therefore obvious since 600 years that this theory was wrong. It is a stunning phenomenon that a theory that is so obviously wrong, could be discussed for such a long time. We even can find it in some textbooks about macroeconomics still today. To keep it short: The question is not, whether the money is backed by products already produced. The question is, whether the money is backed by products that CAN be produced.

The case of Joseph Schumpeter is special. He assumes full employment. In this case there are obviously no unemployed resources and prices will raise. However important is this sentence: "...and the distribution among the different sectors of the economy has changed...".

The logic is this: His charismatic creative - destructive entrepreneur will reallocate the resources by getting access to credits. The credits will allow him to attract the necessary resources paying more, for instance higher wages, than what have been paid before. This will lead to a general raise of prices. The result is that the price structure has changed and the resources are allocated in a more efficient way.

This is not really a detailed description of the money supply. Money supply depends actually on the central banks. They have means to restrict it and to allow the private banks to increase it, but the technical background is not really relevant in the context of this discussion. It is enough to know that the amount of money can be increased and is actually increased.

The expression "unbacked banknote" is only understandable in the context of the gold standard, in force in the time where Theory of Economic Development was first published, in 1911. The gold standard didn't work the way people normally assume it works, but somehow it was backed by gold.

People assume that the whole amount of money circulating was backed by gold and at any moment everbody could go the banks and convert the money in gold. That was not the case and not necessary in order to make that system working.

In the gold standard the central banks fix the conversion rate of money to gold, lets say 3 units of money to 1 unit of gold. Let's say as well for the sake of simplicity that someone earns 3 units of money. If due to general inflation he earns 6 units of money, what corresponds to the same basket of good than before because the prices has raised as well, he can go to the bank and get 2 units of gold and due to fact that gold is stable by nature, it can't increase, the value of gold has remained the same. Therefore he got richer. It is obvious that people will do that, but by doing that, they will reduce the amount of money until the initial relationship is reestablished and there is no further need nor benefit to continue changing money for gold.

However it must be clear that in this system as well the amount of money can increase, however inflation cannot happen. Assuming the goldstandard the theory of Joseph Schumpeter is wrong. The amount of money can increase, no doubt, because the conversion from money to gold is only kind of a fine tuning, but prices cannot increase. Any inflation will lead to a reduction of money.

However this is a problem and therefore finally the goldstandard was not successful. Every change in the economic structure is normally only possible if some prices raise. If the charismatic creative-destructive entrepreneur of the Schumpeter styles needs resources to impose his innovations on the market he needs resources and in a situation of full employment he only gets them if he pays more for them than what have been paid until than. If the innovation has a strong impact on the economic structure, the scenario Schumpeter assumes, this would have an impact on prices what is actually not possible.

We assume, that the scenario of Schumpeter is not realistic. Innovations with a big impact on the economic structure are possible, but normally there are unemployed resources and an inflation is not necessary.

Actually it is strange, see paragraph below, that he emphasis so much on the fact that the amount of money is increased, because this is clear since 600 years and has been already mentioned by David Hume. Beside that the argument that an increase of money would lead to inflation has never been put forward against mercantilism. It seems that everybody was aware that this wouldn't have been a good argument.

However we admit that for academic economists it has to be said again and again, because some of them stick to the idea, until today, that savings, understood as not consumed income of the past, is a necessary condition for investments.

In the next paragraph he distinguish between a credit, increase in the amount of money, used for consumptive purposes and a credit used for investive purposes. Credits for consumption purposes can be as well financed by extra purchase power, but the resources to pay of the credit has to come from somewhere else, because the purpose of consumption is not generate income, but to consume it. Due to the fact that he assumes full employment, prices will increase. Under this unrealistic assumption, an increase in the amount of money will increase prices. Later on, that is his assumption, the credit used to finance consumption will be paid back, purchase power will be withdrawn, supply exceeds demand and prices will fall again.

(He mixes this with a credit for normal transactions, although this case is different. It is well possible that a merchant buys commodities with a credit. But in this case he will get the money back and pay off the credit. Only if it takes him a very long time to pay off the credit, the phenomenon is comparable with a consumer credit.)

The differences for him in comparison to the credit taken buy the charismatic creative - destructor is that this kind of processes will be repeated over and over again, while in the case of a credit used by the schumpeterian entrepreneur the story is finished once the restructuring of the production structure is accomplished.

Man kann den geschilderten Vorgang als Kreditinflation bezeichnen. Aber er unterscheidet sich von jeder anderen Art von Kreditinflation, von der Kaufkraftbeschaffung für konsumtive Darlehen oder für Darlehen zur Durchführung von Geschäftsoperationen des Kreislaufs - denken wir z.B. an die Gewährung von Konsumtivkredit an den Staat - durch ein sehr wesentliches Moment. Auch in diesen Fällen tritt neue Kaufkraft neben die alte, steigen die Preise, erfolgt ein Güterentzug zugunsten des Kreditnehmers oder jener, an die dieser die geborgene Summen auszahlt. Damit bricht der Prozess ab: Die entzogenen Güter werden konsumiert, die geschaffene Zahlungsmittel bleiben in der Zirkulation, der Kredit muss immer wieder erneuert werden und die Preise sind dauernd gestiegen; es sei denn, dass das Darlehen aus dem normalen Einkommensstrom - Steuererhöhungen z.B. - abgezahlt wird: Das ist aber eine neue, besondere Operation (Deflation), die, in sattsam bekannten Kausalnexus abrollend, das andernfalls dauernd gestörte Geldwesen wieder saniert.

Joseph Schumpeter, Theorie der wirtschaftlichen Entwicklung, Drittes Kapitel, Kredit und Kapital

This process can be called credit inflation, but there is a difference between this credit inflation and others, as for instance granting purchasing power for loans used for consumptive purposes o loans that only serve to make possible comercial operations in a normal business cycle - as for instance to grant consumer credits to the goverment. In the last mentioned cases as well the new purchasing power is added to the already existing one, the prices raise, and there is a withdrawal of commodities at the benefit of the borrower or the one the borrower transfer the money. But after that the process stopps. The withdrawn will be consumed and the means of payments remains in circulation, the credit has to be renewed and prices will have raised definitely, unless the loan is paid back is paid back from the normal income - for instance by a raise of taxes. But this is a new and special operation (deflation), which will happen in the well known way and will restore the otherwise imbalanced money system.

What remains of Schumpeter are three different things. 1) Without entrepreneurs and human decision making a market economy will not work. 2) He distinguishes clearly between a steady economy and a dynamic economy. 3) Money is not a pure veil, but have a very real impact on the economy.

None of this insights are really espectacular for normal people. For academic economists all that is revolutionary. It is so revolutionary, that still today there are a lot of academic ecnomists who hadn't understood already.

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a gentle say good bye to steady state economies

Market equilibriums are the result of trial and error and not the result of a perfect market

The market controls the behaviour of the market players in a systemic way, but not in the form of "economic laws" that assumes that human behaviour is completely predictible and human decision making can be substituted by robots. Markets are always an area of tension between objective signals and human decision making.

Schumpeter recognizes that an increase of purchasing power assumes an increase of money, but not of savings.

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