Wednesday, June 17, 2009

Creative destruction

Two propositions about the current economic crisis endlessly recur. First, it is a terrible disaster, comparable only to the great depression of 1929. Second, the situation is the result of inadequate regulation. The appropriate remedy, we are told, is massive government intervention, followed by a straightjacket of renewed regulation.

Such is the conventional wisdom. But is it true?

In all this brouhaha very little attention has been given to the ideas of the Austrian economic historian Joseph Schumpeter (1883-1950), notably his idea of creative destruction. After teaching at the universities of Czernowitz, Graz and Bonn, Schumpeter concluded his career at Harvard. There he began his monumental History of Economic Analysis, published posthumously in 1954. Recently, Schumpeter’s ideas have been illuminated in a superb study by Thomas K. McCraw, Prophet of Innovation: Joseph Schumpeter and Creative Destruction, Harvard University Press, 2007.

The economist's experiences in the 1920s provided vivid personal experience of the volatility of capitalism. In 1919-1920, he served as the Austrian Minister of Finance, with some success, and in 1920-1924, as president of the private Biedermann Bank. That institution collapsed in 1924 leaving Schumpeter bankrupt. This background fostered his influential work on business cycles. Rejecting the work of John Maynard Keynes, Schumpeter began with an account of circular flow. Absent any innovations and innovative activities, this process leads to a stationary state, or equilibrium. However, this stagnant situation is unlikely to remain, for the entrepreneur disturbs the equilibrium. Entrepreneurs are the prime cause of economic development, which proceeds in cyclic fashion along several time scales.

Of great current significance is Schumpeter’s theory of creative destruction, an indispensable component of business cycles as he sees them.

Here are some relevant examples of this process. Companies that once revolutionized and dominated new industries--for example, Xerox in copiers or Polaroid in instant photography--have seen their profits fall and their dominance vanish as rivals launched improved designs or cut manufacturing costs. By contrast Wal-Mart has achieved a strong position in many markets by pioneering new inventory-management, marketing, and personnel-management techniques. The giant company then offers lower prices for retail consumer products. Rival companies, managed by more traditional methods, rapidly lose market share. Over the long term, however, Wal-Mart cannot insulate itself from similar threats by newly innovative competitors.

In music technology, the 78-RPM disk yielded to the Long Play vinyl disk, and that in turn to the CD. Today CDs are being replaced by electronic delivery of music. Unable to compete in the new climate, Tower Records and Virgin USA have closed their doors. Such is the power of creative destruction.

Then there is the process whereby online free newspaper sites such as The Huffington Post and the Daily Dish of Andrew Sullivan are supplanting the traditional paper dailies. At the beginning of the year, the Christian Science Monitor announced that it would no longer publish a daily paper edition, but would be available online daily and provide a weekly print edition. The Seattle Post-Intelligencer became online-only in March 2009. The Rocky Mountain News has ceased to publish altogether. The Boston Globe hangs by a thread.

Creative destruction is a powerful economic concept because it can explain many of the dynamics of industrial change: the transition from a competitive to a monopolistic market, and back again. It has been the inspiration of endogenous growth theory and also of evolutionary economics.

It goes without saying that creative destruction often hurts. Layoffs of workers with obsolete working skills are the price of new innovations valued by consumers. While a continually innovating economy generates new opportunities for workers to participate in more creative and productive enterprises (provided they can acquire the necessary skills), creative destruction can cause severe hardship in the short term, and in the long term for those who cannot acquire the skills and work experience.

In this context the current turmoil in the economy is not bizarre or abnormal. It is an instance of creative destruction, though a very intense one.

Forerunners of the notion of creative destruction have been detected in the writings of Mikhail Bakunin and Friedrich Nietzsche, and in Werner Sombart's Krieg und Kapitalismus (War and Capitalism), where he wrote: "again out of destruction a new spirit of creativity arises." Indian religion supplies Kali, the goddess of destruction, whose devastation prepares the way for new growth.

Going well beyond his predecessors, Schumpeter offered a more comprehensive vision, stressing innovative entry by entrepreneurs as the force that sustained long-term economic growth, even as it destroyed the value of established companies that enjoyed some degree of monopoly power. Business cycles are a normal process, Schumpeter believed, being fueled by innovations. In his honor the process is sometimes termed “Schumpeter’s Gate.”

In 1942 he put it this way: “The opening up of new markets and the organizational development from the craft shop and factory to such concerns as US Steel illustrate the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one ... [The process] must be seen in its role in the perennial gale of creative destruction; it cannot be understood on the hypothesis that there is a perennial lull.”

Since Schumpeter’s death the model has seen further development. In 1992 the idea of creative destruction was put into formal mathematical terms by Philippe Aghion and Peter Howitt in their paper "A Model of Growth through Creative Destruction," published in the journal Econometrica.

In 1995 Harvard Business School authors Richard L. Nolan and David C. Croson released Creative Destruction: A Six-Stage Process for Transforming the Organization. The book advocated downsizing to free up slack resources, which could then be reinvested to create competitive advantage.

Max Page took up the idea of "creative destruction" in his 1999 book, The Creative Destruction of Manhattan, 1900-1940. In this volume Page attempts to capture the complex historical circumstances and economics, social conditions and personalities that have produced crucial changes in Manhattan's cityscape. This process, still ongoing,has lead the sad phenomenon of “Lost Manhattan,” the roster of noteworthy and historic buildings that have perished in this way, including the original Pennsylvania Station.

During the boom decade that followed the publication of Page’s book, the sight of soaring new buildings has appeared all around. At the same time, some brake has been placed on the frantic pace of new development by the official process of Landmarking, which blocks the demolition or even major renovation of buildings deemed of historic importance.

Care must be taken to see that the exemptions due to Landmarking are not too extensive, because such excess would strangle development, and the city would risk becoming a sterile mass-museum.

The urban situation is paradigmatic of the larger approach that should be followed. There needs to be some regulation, but not so much as to stifle growth. We are told that President Obama understands this minimalist principle. Yet powerful forces are now beating the drum for a vast new regime of regulatory interference.

At all events, the perspective afforded by Schumpeterian creative destruction offers reassurance. The process is painful, but it is not something that should inspire horror. We are simply experiencing an intense version of a normal process--one that, despite the pain it inflicts on individuals, is an essential component of economic growth.



Anonymous Anonymous said...

Great post. I, too, admire Schumpeter's work in economics, but you omitted the central theme of his concern that an unregulated economy would gradually enfold the co-conspirators of governmental bureaucracy and commercial bureaucracy, and the ultimate merger into de facto socialism.

In other words, a non-competitive marketplace inevitably leads to monopoly. Thus, Walmart, Microsoft, U.S. Steel, become a governmental entity by predatory pricing, by de facto approval of bureaucracy, and impossible without demands to stay in business. Most U.S. firms CANNOT supply Walmart's voracious dominance, because Walmart goes to China with its subsidized labor, and our lack of tariffs, to underprice ALL competition. UNLIKE public and private utilities owned monopolistically, and regulated by "oversight" agencies from our payments, these firms are quasi-government entities, which serve a marketplace without a competitive market. Some people prefer to "nationalize" these entities, but the PG&E paradigm with governmental oversight of monopolistic practices allows private initiative to act, rather than the inertia of civil servants, for whom efficiency is a four-letter word.

Thus, the Sherman Anti-Trust Act of the 1890s requires strict enforcement, insisted Schumpeter, lest any single player on the field of the game of economy dominate prices, restrict competition, and deny consumers choice, where the dynamics of the market cannot, or does not, function. Most of Walmart's success is NOT by inventory control, but by importation (with little tariffs) from subsidized labor from China goods that are grossly underpriced. When the market-share of companies like Walmart exceeds 70%, then the Anti-Trust Acts should be applied, to keep choices for consumers, obviate Walmart's dominance, and prevent cooption rather than cooperation and competition from functioning in tandem.

Moreover, you do not distinguish the different types of regulation. In 1954, business and lawyers came together to cobble the Uniform Commercial Code to expedite business functions and obviate 1,000 page contracts. Ideally, the Congress was meant to adopt the U.C.C. under its commerce clause. It chose not to, and instead was adopted with extreme variations state by state. This kind of regulation is ESSENTIAL to all forms of commerce, industry, and trade. Instead of slicing and dicing rain forests for contracts, each state "presumes" the U.C.C., which is LONG OVERDUE for update. It is this, that caused our current problems.

Likewise the Glass-Steagall Act, the Federal Deposit Insurance Corporation, and other regulators failed to do their jobs BECAUSE Congress insisted upon it with Presidential appointments of incompetence throughout the regulatory agencies.

Regulation must be seen as a sort of "rules of the game that players on the field of economy," analogous to players of Milton-Bradley's board game "Monopoly," all agree to play by. All it takes is ONE person to exploit all fishing reserves for immediate profit, but an end to numerous species. (See, Robert Frank).

The current proposals for incest between the Executive Branch and business is not "regulatory," but indeed the socialism of risk for private industry, which all Austrian economists deplored. Now that we've embarked on 20% taxpayer ownership of industry and finance, who has the final word? Under Obama's scheme, his Administration. I think this goes way too far. Regulation does NOT own the means of production, it simply provides the "rules of the game."

11:56 AM  
Anonymous Anonymous said...


Rarely does industry police itself, and anyone who has worked within large businesses knows that corners will be cut, unsafe working conditions prevail, and pervasive bilking throughout the chain of industry.

In a remarkable, but highly unusual, feat, the fishermen and women of Northern California collectively required their colleagues NOT to fish this year for the highly-prized Pacific Salmon, because the stocks are too small, and fishing this year may provide profits this year, but no Pacific Salmon ever again.

Instead, the fishers "police" the waters in order to prevent "cheaters" from exploiting the Salmon and undermine the fishers livelihood. The forebearance is not only remarkable, it is so rare, it garner WWII headlines. NO PACIFIC SALMON THIS YEAR. Even restauranteers promised not to purchase it if offered. Unfortunately, NOT all people are non-cheaters, as Darwinian sociobiology has repeatedly demonstrated. Wishful thinking is not in the fishers thinking either, so they are SPENDING their money, time, and resources to Police their environs. The Legislature approved "regulations" for the industry against cheating, which your post ignores entirely.

As Robert Frank noted, this self-policing virtually never happens, but rather someone harvests the last, pockets the profits, and denies fishermen their employment, denies banks repayment of their equipment, and eliminates supply for the market. PERMANENTLY. By contrast, California's wild Salmon fishers did NOT do what those in Boston's Harbor have done repeatedly: Harvested all the species in a year, leaving none for future generations. It only takes ONE cheater entrepreneur to ruin the entire market permanently, and California is ahead of the world in their fisher choices. Also, extremely unusual.

12:09 PM  

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