International Workshop Marshall, Schumpeter, and Social Science th March 2007 Sano Shoin, Hitotsubashi University. Schumpeter on Development

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1 International Workshop Marshall, Schumpeter, and Social Science th March 2007 Sano Shoin, Hitotsubashi University Schumpeter on Development Harald Hagemann University of Hohenheim, Stuttgart, Germany Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 1

2 Schumpeter and the German Historical School According to Shionoya, Schumpeter understood the essence of the German Historical School as comprising 1. A belief in the unity of social life and the inseparable relationship among its components 2. A concern for development The greatest significance of the historical method for Schumpeter was the recognition that historical materials reflect the development phenomenon and indicate the relationship between economic and non-economic facts, thus suggesting how the disciplines of the social sciences should interact. Yuichi Shionoya, Joseph Schumpeter and the German Historical School, (1999: 9) Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 2

3 The Lost Chapter (7) of Schumpeter s Theory of Economic Development Thus this edition above all has been shortened. The seventh chapter of the first edition has been left out completely. In particular the fragment of cultural sociology, which it contained among other things, now and then has distracted the attention of the reader from the problems of dry economic theory whose solutions I want to understand, and sometimes given to me a kind of consent which I find as annoying as the refusal of not being able to follow. Schumpeter, Preface to the second German edition 1926: XI; my italics Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 3

4 The Lost Chapter (7) of Schumpeter s Theory of Economic Development In the Preface to the first German edition of The Theory of Economic Development Schumpeter (1911, p. VIII) points out that he had started his analysis with the concrete theoretical issues involved in the crisis problem in Furthermore, he makes clear that this book and his earlier one on Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie (The Nature and the Main Content of Theoretical Economics) (Schumpeter 1908) form an entity, although the second one can be read independently of the first one. The division of labour between the two books can be understood best with regard to the two masters Walras, Schumpeter's great hero, and Marx, whose views on the long-run development of the capitalist economy form a life-long challenge for Schumpeter. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 4

5 The Lost Chapter (7) of Schumpeter s Theory of Economic Development In the Preface to the Japanese edition he emphasizes that Walras provided us with a theory which embraces "the pure logic of the interdependence between economic quantities", whereas Marx's genuine contribution to economics is "a vision of economic evolution as a distinct process generated by the economic system itself" (Schumpeter 1937, pp ). This corresponds to the distinction between static and dynamic analysis, which plays a major role in his work. Due to the influence of Frisch in contrast to the 1926 German edition in the 1934 English edition the terms statics and dynamics are fully replaced by the concepts of the circular flow and economic development Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 5

6 The Lost Chapter (7) of Schumpeter s Theory of Economic Development Accordingly, Schumpeter s economic dynamics deals with the changing of the data of the static system, or the destruction of the circular flow by the carrying out of new combinations that includes the five cases of the introduction of new methods of production, new products, the opening of new markets, new sources of supply, and new forms of organization. In Schumpeter s system economic dynamics is strongly linked to the phenomenon of economic development. The main carrier of economic development is the pioneering entrepreneur, who is an endogenous force in the economy and in marked contrast to the great majority of people limited to taking routine actions only. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 6

7 The Lost Chapter (7) of Schumpeter s Theory of Economic Development In Schumpeter s view not only the final chapter 6 but in fact any single page of his Theory of Economic Development is dedicated to the problem of the business cycle,[1] and analyzing business cycles means neither more nor less than analyzing the economic process of the capitalist era (Schumpeter 1939, p. V). Economic Development in the sense of Schumpeter is endogenous, spontaneous and discontinuous. It is the task of dynamic theory to explain the origin and effects of these transition processes which essentially are a disturbance of equilibrium. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 7

8 Credit and Innovations in Schumpeter s BCT (1) The importance of innovations and credit is at the very center of Schumpeter s Theory of Economic Development. As Streissler has emphasized, it were not the figure of the pioneering entrepreneur and the importance of bank credit for economic development that were new in Schumpeter but rather the idea of creative destruction by innovations and the notion that bank credit was the prerequisite of innovations and of the foundation of new enterprises. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 8

9 Credit and Innovations in Schumpeter s BCT (2) The innovating entrepreneurs need financial means for their investment activity which is given to them in form of credit by the banking system. Schumpeter shares Wicksell s view that the disturbance of economic equilibrium primarily emerges because of an enlargement of profitable investment options, leading to an increase of the natural rate of interest in Wicksell s Interest and Prices (1898), rather than by a lowering of the money rate of interest below the level of the natural rate by the banks, thereby causing a period of expansion which is unsustainable. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 9

10 Credit and Innovations in Schumpeter s BCT (3) The latter is emphasized in the works of his two compatriots Hayek s Prices and Production and Mises s Theory of Money and Credit. There, the bust is the inevitable consequence of the credit-induced boom in which the reallocation to excessively roundabout methods of production is corrected. Mises s argument of excessive credits by the banking sector as the decisive cause of cyclical fluctuations is most clearly stated in his Monetary Stabilization and Cyclical Policy (1928), in which he not only distances himself from views still held by Schumpeter but even from his own earlier views. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 10

11 Credit and Innovations in Schumpeter s BCT (4) Schumpeter s assumption that available resources are fully utilized in the stationary circular flow implies that the carrying out of new combinations requires a different employment or reallocation of these resources. The entrepreneur must resort to credit if she wishes to carry out new combinations since they cannot be financed by the returns from established production activities. Schumpeter also considers saving as a result of previous development. The financing of innovations by means of credit is the function of the banking system. In Schumpeter s view the banker is not the trader but the producer of purchasing power. [C]redit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power (Schumpeter 1934, p. 107). Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 11

12 Credit and Innovations in Schumpeter s BCT (5) The consequence of the creation of new purchasing power out of nothing, i.e. not rooted in previous savings, is an increase of aggregate demand in monetary terms, which leads to an increase in prices. The credit-induced inflation acts as a tax on the mere managers stiffened in routine actions thereby implying a reallocation of productive resources. Although interest on capital is a monetary phenomenon, it is ultimately based on a real factor: the productivity-enhancing effects of innovations. Schumpeter thus makes forced savings, which play an important role in the analyses of his contemporaries Wicksell, Mises, Hayek and Robertson ( imposed lacking ) but were already an argument in Henry Thornton as early as 1803, an integral part of his theory. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 12

13 Credit and Innovations in Schumpeter s BCT (6) However, in contrast to Mises and Hayek who were adherents of the orthodox doctrine that only voluntary savings can create sustainable capital and held the view that the granting of a volume of credit which transcends the level of voluntary savings by the banking system inevitably leads to a crisis, the creation of money and credit for Schumpeter is an essential condition for the financing of innovational activities and thus development in competitive capitalism. Moreover, the credit system is no very active factor in the mechanism of cycles. It adapts itself to the demand which comes from entrepreneurs and submits to contraction by their repayment of loans. In both cases its role is rather a passive one (Schumpeter 1931, p. 17). idea of endogeneity Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 13

14 Credit and Innovations in Schumpeter s BCT (7) Schumpeter opposed the idea that the succession of prosperity and depression is a purely monetary phenomenon. Three factors are considered: 1. The competition for the scarce means of production causing price increases of investment goods in the boom. 2. The decline in prices when the new products enter the markets as the consequence of the enlarged productive capacities, thereby making a depression unavoidable. 3. Then the entrepreneurs use their returns for paying back their debts causing a credit deflation just in that period when the additional goods which could take away inflationary pressure as a consequence of the abnormal credit inducing the boom could be produced in a regular manner. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 14

15 Credit and Innovations in Schumpeter s BCT (8) Schumpeter s views found the most innovative resonance in the contemporary German literature in Ludwig Albert Hahn s Volkswirtschaftliche Theorie des Bankkredits (Economic Theory of Bank Credit) (1920), a fact which is explicitly emphasized by Schumpeter in the second edition of TED when he refers the reader to Hahn s original and meritorious book, which has essentially advanced our knowledge of the problem at the beginning of his discussion of the nature and function of credit (Schumpeter 1934, p. 95, fn. 1). Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 15

16 L. Albert Hahn s Economic Theory of Bank Credit Hahn emphasizes, as later Keynes, the deflationary effects of voluntary savings and the positive effects of an expansionary credit policy for innovations and employment. A key statement reads: Capital formation is not the result of saving but of credit. (Hahn 1920, p.120) Hahn takes up Schumpeter s distinction between normal and abnormal credit and elaborates the distinction between non-inflationary credit (in the amount of overall savings) and inflationary credit due to the money-creating ability of the banking sector. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 16

17 Schumpeter vs. Hahn (1) However, Schumpeter (1926) in the 2 nd German edition of TED, feels obliged to keep some distance from Hahn, whose much stronger emphasis on the directly production-enhancing effects of an inflationary credit creation caused his accusation as an inflationist, when he points out: Against his formulation it appears to me correct to say: although not by existing goods, the quantity of new purchasing power that it is possible to create is supported and limited by future goods. (p. 165) Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 17

18 Schumpeter vs. Hahn (2) It is clear that for Schumpeter the spending of credit for innovative investments is decisive, not for increased consumption. This becomes particularly evident in his statements on capital which is regarded as a fund of purchasing power. Capital is nothing but the lever by which the entrepreneur subjects to his control the concrete goods which he needs, nothing but a means of directing the factors of production to new uses, or of dictating a new direction for production. (TED 1934, p.116). Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 18

19 The Business Cycle as a Superposition of Different Waves (1) In his Business Cycles, Schumpeter (1939) distinguishes four phases of economic fluctuations: prosperity, recession, depression and recovery, and presents a three-cycle schema, in which Kondratieff long-waves constitute the framework where they are combined with the classical Juglar and the shorter Kitchin cycles. In the preface to the English edition of TED we find the following statement: I took it for granted that there was a single wave-like movement, viz. that discovered by Juglar. I am convinced now that there are at least three such movements, probably more, and that the most important problem which at present faces theorists of the cycle consists precisely in isolating them and in describing the phenomena incident to their interaction. But this element has not been introduced into the later editions (1934, p. IX). Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 19

20 The Business Cycle as a Superposition of Different Waves (2) This statement is not surprising because the Kitchin and the Kondratieff cycle were born in the economic literature only in the 1920s. Schumpeter himself was the co-editor of the journal in which Kondratieff s famous article on The long waves in economic life was published in German in However, it is quite interesting to notice that the idea of superposition of different complexes of causality was already there when Schumpeter presented the main ideas on the wave-like fluctuation in economic activity to the Harvard faculty shortly before the outbreak of World War I. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 20

21 Long Waves of Economic Cycles (1) Kondratieff (1)-, Juglar (2)- and Kitchin (3)-Cycles Schumpeter s basic idea that cyclical fluctuations consist of many waves: a composite of three cycles of different length. Source: Schumpeter (1939), p. 213 Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 21

22 Business and Growth Cycles (1) Business Cycles Kitchin cycle Length: 3-5 years Inventory investment Juglar cycle Length: 7-11 years Machinery equipment Growth Cycles Kuznets cycle Length: years Investment in buildings Kondratieff cycle Length: years Basic capital innovations Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 22

23 Business and Growth Cycles (2) Schumpeter (1939) 3 Kitchin cycles = 1 Juglar cycle (3) (9) 6 Juglar cycles = 1 Kondratieff cycle (9) (54) Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 23

24 Business and Growth Cycles (3) The jerky character of economic evolution can hardly be denied and it is one of Schumpeter s great merits to emphasize the importance of integrating the study of business cycles with an analysis of long-run economic development which does not follow a steady-state or balanced growth path. Innovations are not only the decisive impulse of cyclical fluctuations but the period of their implementation also determines the different length of the cycles. With some qualification with regard to the Kitchin the simultaneous presence of cycles of different order for Schumpeter is a problem of interference only and not a problem of different causation. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 24

25 Business and Growth Cycles (4) Schumpeter s monocausality argument also is at odds with the later understanding of economic theory that the cycles of different duration are related to different types of investment goods as the causal factor, i.e. that we have to distinguish between fluctuations in inventories (Kitchin), fluctuations in fixed capital investment (Juglar or Marx s echo effect), fluctuations in construction investment (Kuznets) and fluctuations in basic capital goods as the medium for basic innovations (Kondratieff). Although Schumpeter was willing to consider and integrate the most recent and important developments in economic theory, he clearly did not want to change his early vision laid down in his theory of economic development. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 25

26 Business and Growth Cycles (5) Name Kitchin cycle Juglar cycle Kuznets cycle Kondra-tieff cycle Type Business Cycle Business Cycle Growth Cycle Long Waves Length 3-5 years 7-11 years years years Causal Factor Fluctuations in inventories Fluctuations in fixed capital investments Fluctuations in construction investments Fluctuations in basic innovations and/or basic capital goods Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 26

27 Long Waves of Economic Cycles (2) Long Waves Important Innovations Prosperity Recession Depression Recovery 1. Industrial Revolution (Division of labour, steam engine) Railroads, Steel Mechanization Electricity, Automobiles, Chemical Industry Atomic Energy, Computer, Robots, Electronics Information and Communication Technologies, Biotechnologies Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 27

28 Long Waves of Economic Cycles (3) In the lost seventh chapter of the first German edition of The Theory of Economic Development (Schumpeter 1911) Das Gesamtbild der Volkswirtschaft (The Overall View of the Economy), Schumpeter had analysed already the theoretical and historical development problem and emphasized the importance of statistical analysis. He recognized that economic development is essentially discontinuous since innovations arise unevenly over the various industries. Entrepreneurs are followed by many imitators so that innovations tend to cluster. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 28

29 Long Waves of Economic Cycles (3) However, not only the much broader sociological approach but also the style of the seventh chapter differed substantially from the other chapters so that Schumpeter omitted it from the later editions. The subtitle of Business Cycles as well as his later sociological studies, including his seminar on Pareto at Harvard in the late 1940s, indicate that Schumpeter at the end came back to his roots. He clearly kept his ambitious research program which comprises a genuine interest in dynamics, as is indicated by his early contributions on crises theory and business-cycle theory. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 29

30 Long Waves of Economic Cycles (4) Schumpeter argued against the biological analogy which the use of the term evolution can imply. This comes out most clearly in the first German edition of his opus magnum Theorie der wirtschaftlichen Entwicklung (1911/12), which has recently been republished by Duncker&Humblot in Berlin. Furthermore, in the article Development, written as a contribution to the Festschrift for Emil Lederer in 1932 but only published in the JEL 2005, Schumpeter also makes it very clear in a Max Weberian manner that he wanted to protect himself against an unscientific connotation of the term Entwicklung (development) with value judgements of progress. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 30

31 Long Waves of Economic Cycles (5) However, whereas he kept the cautious attitude against the biological analogy until his death and argued against the dilettante use of the term evolutionary in economics especially at the beginning of chapter II ( The fundamental phenomenon of economic development of the 1934 English version of his Theory of Economic Development TED (pp. 57ff.), he seems to have modified his attitude toward the use of the term evolution shortly afterwards. In a letter to Stewart S. Morgan of May 18, 1934, two months after he wrote the preface to TED, Schumpeter refers to his book as The Theory of Economic Evolution (see U. Hedtke, R. Swedberg, eds., Joseph Alois Schumpeter, Briefe/Letters, Tübingen 2000: Mohr Siebeck, p. 267), and in his subsequent Business Cycles main conceptual chapters such as III ( How the economic system generates evolution ) and IV ( The Contours of Economic Evolution ) takes up the term evolution as a key ingredient. Schumpeter now fundamentally defines economic evolution as the changes in the economic process brought about by innovation, together with all their effects, and the response to them by the economic system (1939 I: 86). Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 31

32 Development Economics (1) I realise now more clearly than in earlier years how deeply relevant many of its (TED) themes are to the development of poor countries and the problems of underdeveloped countries. I would single out two key themes: first, the great importance of technology, innovation, access to innovation and ability and the means of linking innovation with the production process in the form of new products or new processes or the development of new markets. Hans Singer, The Influence of Schumpeter and Keynes on the Development of a Development Economist (1997: 131). Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 32

33 Development Economics (2) Secondly, there is the emphasis placed on the fact that development represents a disruption of familiar and traditional processes of stationary circulation, arousing resistances and hurting established interests. How modern and up-to-date does this approach to development sound: By development we shall understand only such changes in economic life as are not forced upon it from without but arise by its own initiative, from within. Shades of self-reliance, self-sustaining growth, dependency, backwash effects and all that! It took me many years of work in development studies before I came back to the full implications of this definition. These two great themes of Schumpeter s Theory of Economic Development now seem to me the key to the problems of development in poor countries. Universität Hohenheim, Lehrstuhl für Wirtschaftstheorie, Prof. Dr. Harald Hagemann 33