Wednesday, April 30, 2008

Schumpeter's Century

Schumpeter’s Century

The full version of this appeared in The American Interest.

The history of the 20th Century is invariably told as a political and military narrative: the battle of world’s democracies first, with the Soviets, to defeat fascism and second, against the Soviets, to defeat communism. Far less well appreciated, but arguably more relevant to the present, is the economic subtext of the same history: the rise and (partial) fall of large-scale, centralized production. This second story is brought into sharp focus in a newly published biography of the great Austrian economist Joseph Schumpeter, authored by Harvard Business School Professor emeritus and Pulitzer Prize winner Thomas McCraw.[1] Understanding Schumpeter’s life, work, and legacy may not quite equate with understanding the entire scope of the last century, but—particularly given that Schumpeter died at age 67 in 1950—it comes remarkably close.

Insights afforded on the interwar years by McCraw’s biography of Schumpeter are to be expected. Yet the real power of Schumpeterian analysis for today’s readers, and the focus of this essay, comes in its application to the period from Schumpeter’s death in 1950 to the present. What really caused the collapse of the Soviet Empire? Not Ronald Reagan. How does the threat of Islamic Fundamentalism today compare with the threat of Fascism in the 1930s or Communism in the 1950s? From the standpoint of economic fundamentals, it doesn’t. What is the key to China’s sustained economic growth? Not cheap labor. If proper understanding of the takeaways from the last century is a prerequisite for framing sensible policies for the next, then McCraw’s biography of Schumpeter is essential reading.

The Champion of Innovation

For a man who became the world’s leading authority on societal disruption, Joseph Alois Schumpeter could not have had a more stable family history: for over four centuries the Schumpeters resided in, and dominated, the small Czech town of Triesch. For Joseph Schumpeter, this stability came to a sudden end at the age of four, in 1887, when the death of his father prompted his mother to move with him to the Austrian city of Graz. With his mother as his tireless promoter, Schumpeter ultimately received his education in the best schools of the Austro-Hungarian Empire—at that time, among the best anywhere.

From there, his ascent was more uncertain and halting than one might have expected given the eminence he ultimately achieved, a function of the tremendous upheavals of the times. A sequence of teaching appointments following completion of his doctoral studies at the University of Vienna led ultimately to an appointment at Harvard, fortuitously timed to remove Schumpeter from Germany immediately prior to the rise of the Third Reich. It was at Harvard that Schumpeter built his reputation as one of the most expansive and incisive thinkers of his era, and where he wrote what is regarded as his greatest work, Capitalism, Socialism, and Democracy.

Schumpeter’s career as an economist coincided with the birth of modern corporate capitalism. Schumpeter observed directly the emergence of the world’s first large scale companies and the corresponding ascendance of the first great captains of industry (Carnegie, Thyssen, Ford, and other legends-to-be). The advent of capitalism-at-scale induced major social and economic dislocations, but at the same time drove a tremendous increase in the availability of low-cost consumer products, substantially enhancing workers’ quality of life.[2]

To describe the process by which new and innovative firms and industries displaced old and outmoded ones, Schumpeter in Capitalism, Socialism, and Democracy coined the phrase “creative destruction.” This phrase has become so closely associated with Schumpeter that it is easily taken to be his most significant intellectual contribution.[3] This is unfortunate. To sum up Schumpeter with this one phrase is not too different from remembering Shakespeare as the guy who puzzled whether it was better “to be or not to be?” Schumpeter can no more accurately be described as an early business strategist than the Bard can as a pioneering existentialist.

Indeed, the scope of Schumpeter’s work was almost absurdly broad when compared with the highly specialized norm that predominates in academia today. From the outset he sought no less than to arrive at an integrated, scientifically-based set of principles that could explain the full scope of modern economic history. The localized phenomenon of creative destruction was, for Schumpeter, only one element of a research program that aimed at a formal understanding of the microeconomic drivers of business cycles and global historical trends. Schumpeter’s insights extend well beyond what can be grasped by one or even a dozen company case studies. His most ambitious, though not his most successful, work, is revealingly titled Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process. That he is rightly regarded as one of the great social scientists of the 20th century despite having apparently failed in the core project of his career is testament to the magnitude of his aspirations. To understand Schumpeter’s contribution we do well to follow the example of his biographer, accepting no less of a challenge than the rethinking of a century of human history.

A Brief History of the 20th Century

At the start of the 20th Century, the economic landscape was being transformed by the emergence of an entirely new form of business entity, larger and more complex than any that had existed previously. The growth of these private-sector Leviathans was due primarily to what economists refer to as “economies of scale”: the ability to reduce costs per unit by (1) increasing the quantity of output and/or (2) integrating within a single business entity the different stages of production from the acquisition of raw materials to the assembly of a finished product. Economies of scale proved so powerful at the turn of the last century that the individual and companies able to exploit them succeeded in revolutionizing existing industries and building new ones in a matter of years.

The automobile is a particularly remarkable instance of the phenomenon. A consumer good that did not exist at the time of Schumpeter’s birth was, by the time he reached 40, the dominant industry in the world’s most rapidly growing economy.[4] The Rouge factory built by Ford in Dearborn, Michigan in the mid-1920s is the epitome of the process of centralization of integration characteristic of the first part of the 20th century. At one end of the facility occupying over a square mile and employing over 100,000 people, barges unloaded iron ore, coal, and limestone; at the other end exited nearly all the components that made up the Model T; only the final assembly took place at another plant.

The Rouge was quintessential Middle America of the time, yet in photographs taken from the air it resembles nothing more than the highest form of Socialist Realism: at once impersonal and heroic, gritty and majestic. The resemblance is no coincidence. The harnessing of the power of scale and scope was a global phenomenon. It found its most dramatic expression not in Standard Oil, Ford Motor Company, or Thyssen Steel, but rather in the USSR. Absolute political control allowed the Soviets to undertake an unprecedented experiment: placing the entire productive apparatus of a nation under the control of what was, at least in theory, a single administrative authority. If, as appeared to be the case in the 1930s, economic power was rooted in the ability to harness economies of scale, then the decentralized market economies of the West seemed to have ample reason to worry. No one would be able to match the Soviets.

The downfall of Communism, now a matter of historical fact, has been so fully integrated into today’s zeitgeist that it is difficult, even upon reading McCraw’s narrative, to fully grasp the extent of this fear. The incursion of socialism, driven in large part by dissatisfaction over inequalities of wealth naturally generated by corporate capitalist development, was a key element. But what concerned Schumpeter more deeply was the threat to the vitality of capitalism posed by the inexorable movement of large corporate entities toward managed stasis.

To be clear, Schumpeter had no antagonism toward big business. Among economists of the time, he was singularly insistent upon the importance of appreciating the benefits of large-scale production for consumers and society in general. In the address he delivered as President of the American Economic Association in 1949, he chastised the profession for systematically failing to distinguish monopoly from big business: where the former could harm consumers by restricting output to increases prices, the latter had in fact generated most of the cost reductions that had been enjoyed by consumers over the prior century. That offending monopolies were also big businesses did not imply that the inverse was true.

Yet, for Schumpeter, the leading men (and, very occasionally, ladies) of the capitalist system were entrepreneurs. Schumpeter’s description of the entrepreneurial process found its first expression in The Theory of Economic Development, published in 1911. That book is to the study of the economics of entrepreneurship and innovation what the Socratic dialogues are to philosophy. Among the many conceptual contributions of the work is the first clear expression of the economically vital distinction between invention and innovation—the latter being, to Schumpeter, far more important than the former. Economically, Schumpeter stressed, an invention is of no importance until it is brought into use. Had Thomas Edison only invented the light bulb, and not innovated the organizational and technical apparatus for large-scale electrification, incandescent light would have been a historical curiosity, not unlike the technical sketches of DaVinci.

However, as Schumpeter describes eloquently in The Theory of Economic Development, the personal capabilities required of an economic innovator—the creator of “new combinations” of economic activity—are entirely different from those required of an inventor. Very few people are able to do both. As a consequence, the process of converting an invention into an economically meaningful innovation almost always involves a potentially difficult conversation between the person with expertise in technology and the person with expertise in markets.[5] Schumpeter was keenly aware of this divide, and consequently of why it was such a remarkable achievement of capitalist economies to have developed mechanisms for the provision of finance to entrepreneurs. Such “venture capital,” as Schumpeter himself was among the first to call it, played an absolutely central role in the development of capitalist economies.

It was for this reason that Schumpeter saw, as early as the mid-1920s (before the Great Depression), a fundamental contradiction in capitalism. The very power of economies of scale that allowed large firms to grow, and that motivated the process of creative destruction, also could allow some successful firms to render the process of innovation routine, and thereby displace entrepreneurs. From Schumpeter’s standpoint the advent of the first corporate research and development operations—precursors to the major corporate laboratories such as Bell Laboratories and Xerox PARC—represented a major threat to the vitality of capitalist economies. In a 1928 paper titled The Instability of Capitalism published in the prestigious Economic Journal, Schumpeter concludes:

Capitalism, whilst economically stable, and even gaining in stability, creates, by rationalizing the human mind, a mentality and a style of life incompatible with its own fundamental conditions, motives, and social institution, and will be changed, although not by economic necessity and probably even at some sacrifice of economic welfare, into an order of things which it will be mere a matter of taste and terminology to call it Socialism or not.

Over a decade later, Schumpeter revisited this theme in Capitalism, Socialism, and Democracy:

Since capitalist enterprise, by its very achievements, tends to automatize progress, we conclude that it tends to make itself superfluous-to break to pieces under the pressure of its own success. The perfectly bureaucratized giant industrial unit not only ousts the small or medium-sized firm and “expropriates” its owners, but in the end it also ousts the entrepreneur.

Given Schumpeter’s finely-tuned appreciation for the beneficial role played by entrepreneurs and antipathy to planned economies, these two paragraphs represent an indisputably bleak vision of the future.[6]

Predicting the Fall of the Soviet Union

As it turned out, Schumpeter underestimated the adaptability of capitalism, and overestimated the adaptability of socialism. For this reason, the core concern of his most widely read work turns out to have been misplaced.

To be sure, the Soviet Union did prove a formidable ally in the Second World War, and then just as formidable a foe for first twenty years or so of the Cold War. In the 1950s Soviet economic growth was dramatic. The launching of Sputnik in 1957 confirmed profound fears in the West that the Soviets were in the ascendancy. In response, Eisenhower initiated a massive new program of military research and development.[7]

It was not Schumpeter but another Harvard economist by the name of Martin Weitzman who, early in his career. would document the structural flaws in the Soviet economy that were beginning to undermine its development even as the United States raced to match its achievements. In a 1970 paper, Weitzman applied the techniques of aggregate production function estimation used by Robert Solow in his seminal papers on technical change in the U.S. economy to identify sources of growth in the Soviet economy. The results were striking. Solow had in 1957 found that 87% of the growth in the U.S. economy over the first half of the twentieth century was a “residual,” not accounted for by accumulation of the traditional factors of production: capital and labor. Solow attributed this growth residual to technological and organizational innovation. Studying the Soviet economy during the interval 1950-1969, Weitzman found that only 15-25% of growth could be attributed to technical change.

For the Soviet economy, output growth through the 1950s and 1960s had been driven almost entirely by the absorption of “surplus labor.” In general, the mechanism for this type of economic growth is a simple one: simply giving underemployed workers the tools they need to be productive. Why is such a strategy for growth inherently limited? Imagine an economy comprised entirely of lawn mowing services. At its starting point, there is one lawn mower for 100,000 people. However, for each new lawn mower produced, another worker is brought into the economy. Through this process of capital accumulation, people are rapidly paired up with equipment that dramatically raises their productivity. However, in this simple example, growth comes to a sudden halt once the last idle worker is paired with a lawn mower. At that point further improvements can only come with technical change and innovation. In the Soviet model, these were not forthcoming. Weitzman notes:

There has always been a suspicion that Soviet emphasis on yearly, quarterly, and monthly plan fulfillment leads to a fear of uncertainty which has discouraged innovation at the local level. Does this mean that a greater degree of local autonomy on issues of innovation and risk taking would help increase the growth of the residual? … With their demonstrated commitment to rapid economic growth, the Soviet leaders may well continue their recent policy of hammering out those pragmatic organizational compromises considered necessary to secure future growth.[8]

Like Schumpeter in Capitalism, Socialism, and Democracy, Weitzman was kind enough to allow that Soviet planners had ability to grasp that continued innovation would be required for growth. But the verdict of history is that a fundamental change to the Soviet system was not forthcoming. The reality as glimpsed by Weitzman and experienced as a daily fact by residents of the Eastern Bloc countries, was that disruptions caused by technical change and innovation were as toxic to Soviet planning as they had been to medieval guilds 400 years earlier. The evidence of such technical stagnation is seen readily in the Trablant and other artifacts of Soviet production that, once in the market, changed little, if at all, during the span of decades. The capability of Soviet scientists to generate world-class inventions was juxtaposed against the incapability of the Soviet economy to permit disruptive innovation. As a direct consequence, the Soviet system was slowly but inevitably headed toward collapse.

The Postwar Economic Miracle in the West

The postwar development of capitalist economies was also more promising than Schumpeter could have anticipated. In the United States in particular, corporate centralization reached its high ebb in the 1950s and 1960s. In the 1970s, investors penalized excessively diversified “conglomerates.” Breakups followed, and the business school cliché “stick to your knitting” began to gain currency. In the 1990s these dual processes (strategic focus and productive fragmentation) continued as even the most tightly focused companies were compelled to respond to a revolution in networked production and outsourcing.

Alongside these processes most relevant to large firms was a dramatic growth in the business of private equity finance, including venture capital, allowing entrepreneurship in the United States in particular not only to survive, but to thrive. Where new ventures had for centuries been fueled by investments from wealthy individuals who perceived the potential for large gains, with the explosion of technological possibilities that followed World War II—in part fueled by huge sums spent by the U.S. Department of Defense on military R&D[9]—the provision of venture capital and its impacts on the economy reached a qualitatively different level. By the peak of the technology boom in 2000, venture capital firms disbursed a remarkable $100 billion in funds. Granted, only a small fraction of that sum went to support high risk, technology-based, new firms of the type that Schumpeter might have considered most critical to long-term growth. But even the less risky resources given to mergers and acquisitions had potential to fuel creative destruction of a sort, as investors (ideally) compelled non-adaptive firms to either change their practices, or have their assets redeployed to other uses. Corporate behemoths continued to dominate the economic landscape, but they now faced an ever growing threat of dislocation from new start-ups.

“It’s Innovation, Stupid”

An understanding of the economic fundamentals of 20th century history is valuable today in multiple contexts. As already suggested, Schumpeterian analysis is helpful in correcting the widespread belief that the demise of the Soviet Union was driven by Reagan-era military spending. The Soviet Empire came to end primarily because its economy was structured in a manner hostile to innovation, and thus was not able to sustain economic growth. Yes, it is possible that the pressure to keep pace with U.S. military spending served as a coup de grace of sorts to the Soviet system. But to exaggerate the U.S. role in the demise of the USSR is to employ the same myopic reasoning that in 1949 brought us the inane question “Who lost China?”

Along similar lines, current comparisons of Islamic Fundamentalism to Fascism in the 1930s or Communism in the 1950s are almost entirely empty when considered from an economic standpoint. Germany in 1930 was a country with demonstrated capacity as a global economic leader whose steady development had been halted at the start of the 20th century only by a pointless war brought to a conclusion by a bankrupting peace. Even Japan, greatly underestimated in the West prior to the attack on Pearl Harbor, was a nation that had steadily built its economic foundation and technical capabilities over the period of almost a century with patient investment and the strategic imitation of Western techniques. In contrast, the countries potentially susceptible to the sway of Islamic Fundamentalist ideologues today compare unfavorably with the Soviet Union of the 1950s from the standpoint of relative economic capability; and do not compare at all with Germany or Japan of the 1930s.[10] This is not to say that such countries could never pose a real and enduring threat to the United States or other Western democracies. It is simply to say that, if such a day ever comes, it is still a long way off.[11]

Of course, innovation and technical change has also created new modes of attack that make small groups potentially threatening today in a way that only entire nations could have been threatening in the past. But an historical perspective is valuable here as well. Consider that over 60 million people lost their lives globally during World War II. Among armed combatants, the United States could count itself lucky in having only lost “only” 290,000 of its 16 million service-members. Such losses are inconceivable today. Yet the capacity for democratic institutions, including decentralized markets, to adapt and respond following the Great War was dramatic. What reason is there to believe that capitalism and democracy are any more fragile today than they were at that time? By what measure can any present threat posed by even the most malicious non-State adversaries compare with the combined industrial might of German, Japan, and other Axis powers faced during World War II, or of the Soviet Bloc during the Cold War? Respect for capabilities of foes and the recognition of the reality of potential threats must be matched with an equally realistic appraisal our societal resilience and capacity for recovery.

If we shift focus from threats to opportunities, it becomes clear that the nations for which a correct reading of the 20th century is most critical are the ones to which Schumpeter himself argued that his analysis pertained at least a century ago: those labeled by Mao Zedong in 1955 “the Third World,” belonging neither to the “First World” of capitalist economies nor to the “Second World” of the Eastern-Bloc.[12]

The spectacular growth of China in particular is often misunderstood as a story of cheap labor. It is not. Cheap labor relative to Western standards existed in China for over a century before the recent surge in development: it was also known as poverty. The Chinese reservoirs of underutilized (a.k.a. cheap) labor are indeed vast, but the talent to work with machines productively is limited, as it is everywhere else. What has changed in the last fifteen years is a combination of that underutilized labor with huge infusions of capital. In places like rapidly growing Donguan in Southern China, even small scale entrepreneurs face the same constraint as large corporations in the U.S.: the scarcity of talent capable to keep up with a world of rapid growth and change. Clearly the talent required of a small scale venture in Guandong Province is of a different type than that required in Mountain View by Google. But the constraint is a real one in both settings.

China’s current growth is a dividend of sorts earned as a consequence of more than a century of economic stagnation. In the early 19th Century, before China fell victim to the superior technology of the British and other colonial powers in the Opium Wars, China comprised over 30% of the world’s economy; today, even after a decade of remarkable growth, that number stands at 4%. For China in ten or twenty years, just as for the Soviet Union in the 1970s, a point will come when matching capital to underutilized labor is no longer an adequate strategy to sustain rapid growth.[13] But in China today, unlike the Soviet Union at any time in its history, entrepreneurship and (economic) creative destruction are flourishing.[14] Furthermore, a profound difference exists between today’s Chinese Communists and yesterday’s Soviet Communists. The Chinese leadership appears from its actions so far to be fully able to grasp the Schumpeterian insight that while political stability requires sustained growth, sustained growth actually requires a significant degree of economic instability.[15]

Waking a Sleeping Giant

While crafting public policies to support innovation is a paramount public priority in Communist-led China as in many other parts of the world, in the United States the topic tends to draw a yawn. The relative lack of interest in innovation policy among U.S. political leaders is unsurprising but worrisome. The very success of the U.S. in technology-based innovation over the period of a century has resulted in a systematic discounting of the substantial role played by government and public policy in driving the innovation process. Even those who acknowledge the importance of innovation tend to believe that government should help spur invention by funding basic research, but not interfere with market incentives to translate inventions into market-ready innovations.

To the extent that the topic of innovation policy has recently received attention, the focal point has been concern over the erosion of U.S. dominance in science and technology, and the attendant growth of R&D outsourcing. Skeptics of an active federal role in this domain will point out, correctly, that recent observed decreases in U.S. scientific and technological leadership are primarily due to a general, and natural, movement toward greater global balance in innovation capabilities; that whatever the unique characteristics of America and of Americans with respect to entrepreneurship and innovation, the greatest single factor contributing to U.S. global economic dominance for the past 60 years is the simple fact that roughly six of out of seven of the world’s major centers of production were destroyed during World War II. The disruption was of epic proportions. Recovery has taken over half a century, and is still in progress.

But awareness of a significant historical trend should not translate into neglect of a vital national resource. In the 20th century, the economic future of any nation rested with its great corporations. “What is good for General Motors is good for America,” went the saying. In today’s world of networked production and distributed innovation, the saying no longer holds. The economic vitality of nations depends primarily upon vibrancy of its most innovative regions, both large and small. A key to developing and sustaining healthy “innovation ecosystems” in the U.S. in the coming century will be the development and implementation of public policies to address seemingly esoteric topics such as the emerging crisis in the patent system, the gradually diminishing fraction of venture capital directed to start-up firms, and the presence of excessive and poorly considered restrictions on the flow of talent into the United States from abroad.

One can only hope, then, that McCraw’s biography of Schumpeter will contribute to a renewed interest in the topic of innovation in general, and its relationship to public policy in particular. Although the 20th century is behind us, Schumpeter’s century is still to come.

Philip E. Auerswald is assistant professor and director of the Center for Science and Technology Policy at the School of Public Policy, George Mason University, and a research associate at the Belfer Center for Science and International Affairs, Kennedy School of Government, Harvard University. He is a founding co-editor of Innovations: Technology | Governance | Globalization.

[1] Thomas McCraw (2007). Prophet of Innovation: Joseph Schumpeter and Creative Destruction. Boston MA: Harvard Business School Press.

[2] See for example Joseph A. Schumpeter, “The Function of the Entrepreneur and the Interest of Workers.”

[3] The title of McCraw’s book, Prophet of Innovation: Joseph Schumpeter and Creative Destruction¸ exemplifies this tendency, although the content for the most part does not.

[4] See McCraw p. 267.

[5] Branscomb and Auerswald, 2001. Taking Technical Risks: How Innovators, Executives, and Investors Manage High Tech Risks. Cambridge MA: MIT Press.

[6] One deficiency of McCraw’s book is that it inadequately develops this important, if not core, theme in Schumpeter’s work, relegating to a footnote the one most pertinent textual reference.

[7] The risks involved in such a re-allocation of resources were not lost on Eisenhower. Four years later he would conclude his term in office by famously describing the threat posed to national well-being by the growth of the “military industrial complex.” Dwight D. Eisenhower, “Farewell Address to the Nation,” January 17, 1961.

[8] Martin L. Weitzman (1970). “Soviet Postwar Economic Growth and Capital Labor Substitution.” American Economic Review 60(4): 676-692 (September).

[9] By the 1960s, U.S. military funded R&D comprised more than 30% of the R&D conducted, not only in the United States, but in the world.

[10] In 1913, prior to World War I, Germany’s economy was the world’s third largest; in 1973, at its relative peak, the Soviet economy was the world’s second largest. In contrast, Iran, Pakistan, and Saudi Arabia are today world’s 22nd, 28th, and 30th largest economies, respectively; and for Iran and Saudi Arabia, oil revenues comprise over 40% of GDP.

[11] Challenges to personal freedom outright crimes against humanity are another matter. Schumpeter himself underestimated the savagery of which the Nazis ultimately would prove capable. Yet, even in the cases of their worst atrocities, the quantity and sophistication of the resources to which the Nazis had access determined their capacity for systematic destruction.

[12] Address at Bandung Conference, April 1955.

[13] In the words from Weitzman’s 1970 paper, “Can the growth in man-hours be stepped up? Probably not. Demographers estimate that the growth of the working age population will not increase in the near future. Nor can industrial laborers be so easily drawn out of agriculture as they might have been in the past.”

[14] Recent embarrassments over product safety, though small scale, suggest that if anything the risk to Chinese capitalism is not from inadequate individual initiative, but rather from inadequate regulation.

[15] The primary published point of reference is China’s 11th five-year plan. See also, Xue Lan and Nancy Forbes (2006). “Will China Become a Science and Technology Superpower by 2020?” Innovations: Technology, Governance, Globalization. 1 (4): pp. 116-126.

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