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. 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
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
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
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.
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. 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. The Rouge factory built by Ford in
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
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. 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.
Predicting the Fall of the
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
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
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.
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
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—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
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.
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
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.
The spectacular growth of
Waking a Sleeping Giant
While crafting public policies to support innovation is a paramount public priority in Communist-led
To the extent that the topic of innovation policy has recently received attention, the focal point has been concern over the erosion of
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
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
 Thomas McCraw (2007). Prophet of Innovation: Joseph Schumpeter and Creative Destruction.
 See for example Joseph A. Schumpeter, “The Function of the Entrepreneur and the Interest of Workers.”
 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.
 See McCraw p. 267.
 Branscomb and Auerswald, 2001. Taking Technical Risks: How Innovators, Executives, and Investors Manage High Tech Risks.
 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.
 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.
 Martin L. Weitzman (1970). “Soviet Postwar Economic Growth and Capital Labor Substitution.” American Economic Review 60(4): 676-692 (September).
 By the 1960s,
 In 1913, prior to
 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.
 Address at
 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.”
 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.
 The primary published point of reference is