Saturday, September 20, 2014
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Schumpeter To Rajan: Unlike Banks “I Died Before I Got Old”

Yesterday Raghuram Rajan published an interesting article on competition in finance. He made the important point that competition was a very positive force in the financial sector after deregulation in the 1980s. The drawback was, however, that forces of competition never really became real in finance as they would be in an ordinary industry, because regulators sheltered banks from the ultimate consequences of failure.

Yet I was left feeling a little puzzled about Rajan’s references to Schumpeter. Rajan seemed to suggest a contrast in Schumpeter’s writing between early praise for competitive entrepreneurial innovation and later tolerance of monopoly. When I read Schumpeter’s early and later writing I was not left with this stark picture of a ‘younger’ and ‘older’ man. My lasting impression was only that Schumpeter cleverly and successfully pulled off the remarkable feat of reconciling monopoly with competition in the special case of innovation.

I thought it would be worthwhile revisiting Schumpeter’s arguments, if for no other reason than to double-check my interpretation. For interest -- though I have proven nothing about the ageing process in so doing! -- the dates of Schumpeter’s publications are provided.

Schumpeter usually began with a positive analysis of crisis and the shifting neighbourhoods of equilibrium and disequilibrium. A balanced system “that at every given point of time fully utilises its possibilities to the best advantage” will not be as good for development as a system that experiences disturbances and continually struggles to improve its performance (1947). Real economic development occurs in disequilibrium, when a disturbance forces the system to depart from the circular flow. The cause is innovation. Continual product and process innovation is the “outstanding fact in the economic history of capitalist society” (1939). “New combinations” of materials and forces of production, and the new ideas that change the way something is produced, sold or consumed, in turn transform economies by generating new industries, firms, ideas, goods, methods, and organisations.

I think Schumpeter’s theory of innovation can be divided into three dimensions of entrepreneurial agency --- 1. leadership, 2. profit motive, and 3. imperfect competition.

- ONE -

Innovation leaders are more important as agents of change than the owners of capital and property, because innovators build the roads that capitalists will walk along (1934). Today we find that large firms often lead in technology development and routinely cultivate entrepreneurial aptitudes within the firm. When Schumpeter studied the innovation process, leaders still were typically individual entrepreneurs, daring and intuitive “new men” in young firms who took bold initiatives and stepped “outside the routine”. Innovators swim against the stream and defy constraints on change. They persuade investors -- who take a commercial view of the viability of an enterprise and the profitability of innovations -- to bear the risks of a new idea and provide the finance for entrepreneurial plans (1934).

Innovation is a behavioural characteristic of capitalism. The psychology of innovators differs from managers who maintain an established business. Schumpeter said: “Everyone knows that to do something new is very much more difficult than to do something that belongs to the realm of routine” (1939). Innovators move production into new channels where the means and ends of economic activity are not calculable. They break conventions, conquer social resistance, and usurp older firms. They win new customers. The neoclassical equilibrium routine, said Schumpeter, does not need this kind of leadership (1934).

- TWO -

Then there is the question of what motivates the leaders of innovation. The usual motive of economic action is satisfaction of wants. Related motives include status rivalry, or the power gained as a result of successful entrepreneurship. Schumpeter believed that noble ambitions and work ethics also influence innovation -- “the will to conquer: the impulse to fight, to prove oneself superior to others, to succeed for the sake, not of the fruits of success, but of success itself, and the joy of creating, of getting things done, or simply exercising one’s energy and ingenuity” (1934). Nevertheless, it is clear that profit is the main motivator of economic innovation. In capitalism, the profit motive coincides with institutional incentives that channel economic action away from politically generated profits and towards market competition and business innovation (1939). Without profit the entrepreneur would not exist.

- THREE -

Having said all that, it becomes necessary to examine the type of competition that encourages innovation. Innovation and competition are directly linked in economic life. As Schumpeter said, “the new does not grow out of the old but appears alongside of it and eliminates it competitively (1934). Competition spreads the benefits of a useful innovation by improving products, creating mass markets, and lowering costs. What was unusual, at least compared with neoclassical theory, was how Schumpeter conceptualised competition. First, the driving force of economic evolution is not price competition but rather “competition from the new commodity, the new technology, the new source of supply, the new type of organisation (1947). 

Furthermore, Schumpeter argued that successful innovation requires “imperfect competition”, i.e. a temporary shelter from competition, because “perfectly free entry into a new field may make it impossible to enter it at all ... As a matter of fact, perfect competition is and always has been temporarily suspended whenever anything new is being introduced -- automatically or by measures devised for the purpose -- even in otherwise perfectly competitive conditions” (1947).

The explanation for the diminishment of competition during an innovation cycle lies with how innovators understand their future profit. Entrepreneurs know the special premium from innovation cannot last. Competitors who mimic that innovation are bound rapidly to reduce the level of profit (1939). The mere threat of competition can elicit behaviour that corresponds to ideal competition (1947). But, the lure of monopoly, even if it is only temporary or partial, is also a tangible incentive to compete. Monopolistic profits are “prizes offered by capitalist society to the successful innovator” (1947).

Schumpeter really was adamant that the monopolistic position of the innovator is temporary and should not receive state support. The monopolist will be “surrounded by a sufficiently broad zone of competition” (1939). In fact, a monopolistic position cannot generally be sustained unless government intervenes to support it.

“[Pure] cases of long-run monopoly must be of the rarest occurrence and … still rarer than … perfect competition. The power to exploit at pleasure a given pattern of demand ... can under the conditions of intact capitalism hardly persist for a period long enough to matter for the analysis of total output, unless buttressed by public authority.” (1947)

By monopolistic ‘shelters’ Schumpeter meant business practices that allow entrepreneurial firms to protect themselves from competitors during periods of major industrial restructuring. Schumpeter was consistently critical of state-administered protections such as import tariffs, subsidised credit, and other political supports that lead to “weakness” and “industries of doubtful value” (1939). Only market competition stimulates true entrepreneurship and maintains the climate of innovation and change. Tactful and reserved state regulation is required. The state must not limit the investment opportunities of entrepreneurs, and should not try to stabilise capitalism by reducing the risk taking on which innovation thrives (1947). State economic action should be confined only to “matters that can be successfully handled by a government”. This necessarily means “a corresponding limitation of the activities of the state” (1947). 

Acceptable or at least lawful strategies by which business can create “temporary shelter” from competition include patents (as Rajan says) but also insurance, hedging, secrecy, inflationary prices, investment strategies that give the firm time to build up its customer base, arrangements to access corporate seed capital, legal agreements to avoid cutthroat competition, and even -- horror of horrors, Schumpeter did not advocate it but tolerated it as an unsustainable tendency subject to eventual competitive destruction -- cartelisation (1947).

I reckon Schumpeter would be horrified to learn that governments systematically prevented creative destruction in the financial sector, and that so many of the consequential losses from private recklessness were assumed by tax payers. I don’t think Schumpeter would have thought it was government’s role to fret in detail about the size or complexity of individual financial entities. Better to have a competitive system with effective bankruptcy in which everyone, including depositors, can take out insurance (he would have enjoyed chatting with Raghuram Rajan and Robert Shiller about insurance market options). As a final undisciplined thought, I believe Schumpeter would have been open to thinking about a shifting techno-economic redefinition of ‘natural monopoly’ state services, and the possibility of reserving special utility status to at least some deposit taking for legitimately risk-averse sectors of populations.

Joseph Schumpeter 'young' and 'older':
(1934) The Theory of Economic Development, New Brunswick: Transaction Publishers.
(1939) Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process, Philadelphia: Porcupine Press.
(1947) Capitalism, Socialism, and Democracy, London: George Allen & Unwin.

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  1. CommentedProcyon Mukherjee

    A superbly written post, Michael, but I have this lingering doubt that the allure of monopoly, due to its tangible and intangible benefits, that could outweigh and surpass the accrued benefits of all that competitive innovation could offer, is the subtle point of inflection, when the odds are high that the bandwagon for monopoly is always such a strong pull. The government on the other hand need not play truant to this by influencing this tendency, especially at a time when competition is already imperfect, which is what the case is for financial markets.

    Procyon Mukherjee

      Portrait of Michael Heller

      CommentedMichael Heller

      Thank you Procyon for your thoughtful comment. You sure are right about financial markets not being perfectly competitive. As for it not being desirable that government play truant, I agree. The issue is what government could practically do when it finally goes back to school. I plead on Schumpeter’s behalf with an old defence that we can’t be sure whether competitive innovation alone would cut down monopolies (without government help), because it has not been tried for a *very* long time.

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