Tuesday, August 24, 2010

The Tragedy of Capitalism According to Schumpeter

I first learned of the famous Austrian economist Joseph Schumpeter as I imagine most economics students do, by his concept of creative destruction. In several of my classes, this merited a footnote or a short passage in a few of my textbooks. In its simplistic form, creative destruction is just the acknowledgement that capitalism is dynamic. That the process by which firms compete, perfectly or imperfectly, takes place over time. And, over time, many of these firms are destroyed and replaced by new firms with better ideas and more motivated owners. This, according to Schumpeter, is the real characteristic that makes free market capitalism so good at raising standards of living.

In studying his most famous work, Capitalism, Socialism, and Democracy, I soon learned that creative destruction is just one part of Schumpeter's work. It is part of, and integral to, his attempt to describe capitalism and its future. Thus, I shall present my interpretation of this system, so that the reader can understand the mind behind creative destruction.

*One important note about Schumpeter is that he seems preoccupied with the concept of
someone being right, but for the wrong reasons. A memorable phrase from his book is, "A prejudiced man may yet speak the truth." He seems to enjoy setting his peers straight by
providing his own logic to justify what they already believe.

Now to the Book:

The Main Argument: "The thesis I shall endeavor to establish is that the actual and prospective performance of the capitalist system is such as to negative the idea of its breaking down under the weight of economic failure, but that its very success undermines the social institutions which protect it, and 'inevitably' creates conditions in which it will not be able to live and which strongly point to socialism as the heir apparent" (Schumpeter 61).

1. The first four chapters of CS&D cover Schumpeter's thoughts on Marxism, which I will not belabor. It should suffice to say that the thesis of this book shows, in my opinion, that Schumpeter thinks Marx is right about the future of Capitalism, but for the wrong reasons. Thus, I will skip discussions of Marxism and save them for a later post.

Chapter V: The Rate of Increase of Total Output
  • Despite periodic recessions, robber barons, and the Great Depression, the western world experienced an average annual growth rate in total output of about 3 percent from 1870 to 1930.
  • This growth has not come at the expense of the poor, as socialists claim. On the contrary, mass production and electrification are examples of the nearly incalculable benefit to the masses of capitalism, while doing very little to improve the standards of living for the very wealthy.
  • The true frustration with capitalism in this period comes from the fact that, despite its remarkable success, it does not yet have the resources to cope with the bouts of high involuntary unemployment associated with the business cycle.
  • Since classical economics, with its comparative static analysis, denies the possibility of involuntary unemployment, it fuels socialist criticism by its inability to explain the business cycle.
  • However, if output continues to grow at this same rate of 3 percent, the capitalist engine will produce enough resources to properly aid the unemployed.
  • Neither the classical economics, nor the socialist economics, can properly explain this continued growth in output.
Chapter VI: Plausible Capitalism
  • In order to determine if output will continue to grow at a rate high enough to alleviate the involuntarily unemployed, one must discern a causal relationship between capitalism and output growth, and understand the mechanism by which this is achieved.
  • Free market capitalism, and the Bourgeois society associated with it, has fostered a more meritocratic elevation of individuals than any previous social structure. Thus, it should at least be concluded that capitalism fosters a more efficient distribution of talents and skills than past economic paradigms.
  • The classical economists were of the opinion that the self interest motive was channeled by free market capitalism in a way that benefited the whole society, and were staunchly against feudal and mercantilist practices. They would immediately attribute the steady rise in output to capitalism.
  • The chief contributions of the classical economists were the observation that the profit motive was actually beneficial to society, and that properly channeled savings were necessary to some degree for aggregate output to grow. But the logic behind their conclusions is flawed.
  • The neoclassical economists, such as Marshall, Walras, and Wicksell, refined the classical observations with partial and general equilibrium analysis which led to the exposition of the First Welfare Theorem. However, the strong assumptions behind this proof make its application limited.
  • The presence of some degree of market power in almost all industries mean that there may be multiple or no static equilibrium in most industries, and that there is no reason to assume that even these equilibrium are efficient. Thus, as Keynes also said, while the neoclassical proof is valid, it is also irrelevant.
Chapter VII: The Process of Creative Destruction
  • Though some degree of imperfect competition seems to be the rule, and it was the case from 1870 to 1930, it can still be true that output growth was due to capitalism. But, a better justification than classical or neoclassical views must be offered.
  • Some argue that, in the early 20th century, monopolistic practices began to destroy the perfectly competitive ideal. But, this is a fantasy history with no basis in fact. The truth is that economic growth and monopolization have increased together.
  • In reality, capitalism is a dynamic process of economic change. Economists real area of study should be how capitalism's meritocratic structure constantly allows for the creation of new things and methods, and irreverently destroys the old ones. This is creative destruction.
  • If it is understood that the timing of creative destruction is uncertain, but its movement is inevitable, monopolistic practices take on a new meaning. High prices, product differentiation, and advertising efforts, are all attempts by firms to extract the most profit from their products, while they last.
  • This will appear inefficient from a static neoclassical perspective, but a statically inefficient process can be dynamically more efficient. And this is true in this case.
Chapter VIII: Monopolistic Practices
  • Taking the process of creative destruction as given, many monopolistic practices turn out to be an attempt to secure long-term investment from the majority risk averse populace. Without them, the extreme uncertainty would make most investment unprofitable.
  • This also explains why price rigidity is observed in many firms over the short run, but is completely lacking in evidence in the long run.
  • The Keynesian observation of sticky prices and wages should be considered valid, and is actually beneficial to a real economy. Perfectly flexible wages and prices could actually lead to a business cycle that spirals out of control at the elation or fright of the population.
  • Considering that monopolistic practices allow for wage and price rigidities, allow some security for long-term investment, are increasingly able to exploit economies of scale, and yet are comparatively short lived due to creative destruction, the case is strong that they are actually a socially beneficial result of capitalism.
  • The neoclassical analysis of perfect competition reached the right conclusion about capitalism, but for the wrong reason. Using perfect competition as the measuring stick for social welfare creates fundamentally flawed regulatory structures, and unnecessarily boosts socialist criticism.

The previous chapters made up the heart of Schumpeter's book. His description of the process of capitalism was unique, and it has been lasting. I will briefly touch on the third part of his book, which concerns his thoughts on why this system of Capitalism cannot last.

The Fate of Capitalism According to Schumpeter

Like Marx, Schumpeter also believed that capitalism had within it the seeds of its own destruction. Unlike Marx, however, Schumpeter believed that it was the great success of capitalism, and not its shortcomings, that would eventually overpower it. He saw its downfall as an inevitable eventuality, and thought socialism was the most possible successor. Of course, this does not make him a socialist, nor a support of socialism, he saw this as a detached assessment of reality.
The simple fact, according to Schumpeter, is that the Bourgeois class is not a fighting class. It is a pragmatic class. While capitalism has allowed their class to exist and thrive, by their nature the majority don't hold onto it with any kind of religious fervor. Socialists, on the other hand, are endowed with such fervor, and a socialist society requires this religious fervor to function. Furthermore, as the capitalist enterprise grows and becomes more complex, a kind of socialized mentality will become increasingly necessary even within the firms. In the end, the Bourgeois class will not have reason nor heart to fight socialism, and it will take the place of the capitalist paradigm.

Too Long To Read Summary: The Austrian economist Joseph Schumpeter described capitalism as a dynamic process of creative destruction. His book, Capitalism, Socialism, and Democracy, is what appears to be his trademark attempt at explaining why someone is right for the wrong reasons. He believes Marx is right, that capitalism must end, but for different reasons. He believes that the classical and neoclassical economists are correct, capitalism is beneficial to society, but for different reasons. It is the meritocratic process of creative destruction that makes capitalism "good"; perfect competition is not useful for these purposes and leads to misconceptions. Monopolistic practices can actually be beneficial because they give some security in an uncertain world and also exploit economies of scale. Capitalism's demise will be due to the pragmatic mentality of the Bourgeois class, and the inevitable socialist takeover will not necessarily be an improvement.

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