Schumpeter Calls Krugman

In the noisy urgent quarrel about economic crisis almost everybody is asking how to get out of recession or how not to get into recession.

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You’d be forgiven for thinking the menu boils down to “growth or austerity”, like a limited choice of “rabbit or fish” in a poor pueblo or kampung restaurant.

Recently Paul Krugman complained to his son with characteristic biting humor:
“Standard economics in this case — that is, economics based on what the profession has learned these past three generations, and for that matter on most textbooks — was the Keynesian position. The austerity thing was just invented out of thin air and a few dubious historical examples to serve the prejudices of the elite. And now the results are in:  Keynesians have been completely right, Austerians utterly wrong — at vast human cost… Nobody ever admits that they were wrong, and Austerian ideas clearly have an emotional and political appeal that is resilient to any and all evidence.”

Running alongside are debates about what famous economists “really said” or “meant to say”. Krugman argues: “Milton Friedman may have opposed fiscal activism, but he very much supported monetary activism to fight deep economic slumps, to an extent that would have put him well to the left of center in many current debates.”

I may be missing something, but in all the blog-slanging I haven’t seen or heard a single defense of Keynes with respect to Schumpeter. When will voices be heard speaking up for what was “really said” by the second or third greatest economist of the twentieth century?

The sensation when I turn the volume down on the “growth vs austerity” noise and revisit Schumpeter -- It’s like being in the centre of a noisy, crowded, chaotic city like Jakarta or Santiago. You go through the doorway of a worn old building with thick white walls, and into a courtyard with a water fountain, small trees, fresh air, total silence except for rustling of papers and clothes behind balustrades on the upper levels, and a marble bench to sit on. It’s a different world. The debate outside momentarily seems, well… slightly ridiculous.

I have the irresistible urge to say something few people dare to say about recession -- the recession of which austerity is really but one element among many. It’s a courtyard moment; just a shift in perspective before going back on the street.

Is recession such a terrible thing? In defence of necessary recession and its symptoms.

Writing either side of the 1930s Depression, Schumpeter developed a sophisticated theory of large business cycles, or Long Waves, shaped by cycles of innovation-led technological change and their related sociological and institutional forces. It drew on historical statistical data that is unreliable by today’s standards. Yet much of the logic of the argument, which Schumpeter insisted did not depend on the numbers, has stood the test of time. A useful introduction to the periodization of the cycle was written by one of my professors at Sussex, Chris Freeman: As Time Goes By: From the Industrial Revolutions to the Information Revolution.

The starting point in the cycle is credit-financed entrepreneurial innovation, a swarm of related innovations which generate a boom. Eventually profits get competed away and innovation subsides, investment declines, bank loans become less productive. When recession sets in there is much over-indebtedness. Easy money during prosperity has typically encouraged dangerous borrowing by consumers as well as producers.

Schumpeter had not heard of modern collateralized debt, securitization, derivatives. But he understood the psychology of risk, speculation, “overdoing” things in an upswing with easy money, “loose banking methods”, and “political encouragement”. The reverse impulses in the downswing of distress selling, bank panics, etc., hasten the spiral into recession and depression.

Where Schumpeter differed from other analysts was in viewing the swings of optimism and pessimism as intrinsically distinct from the underlying unrelenting capitalist process, which is necessarily cyclical. Super-investments in technologies in the boom years need time to be “absorbed” in a fallow period when the economic frontier appears to narrow and “there are no new great things in prospect”. Using monetary and political tools in “attempts to stem the tide” would be “ineffectual”. The downswing is inevitable. After each technology boom, the creditors and debtors will settle their differences one way or another.

The theoretical challenge that Schumpeter posed is evidently enormous: 

“Capitalism is essentially a process of endogenous economic change. Without that kind of change which we have called evolution [lopsided, disharmonious, with violent bursts and catastrophes, like a series of explosions] capitalist society cannot exist... Without innovations, no entrepreneurs; without entrepreneurial achievement, no capitalist returns and no capitalist propulsion. The atmosphere of industrial revolutions is the only one in which capitalism can survive… In this sense stabilized capitalism is a contradiction in terms.

It was difficult even for Schumpeter’s students (e.g. Paul Samuelson) to accept the message in its totality. One of those students, Hyman Minsky, later wrote a very influential book with the title Stabilizing An Unstable Economy, which from Schumpeter’s perspective would be a dangerous “contradiction in terms”.

That’s enough about the ‘model’. Now to the implications:

1. It is a mistake to equate a recession with a decline in the well-being of a society, and prosperity with an improvement. The reverse is true if one considers that prosperity almost always breeds a false sense of security, profligacy, and procedural laxness. In recessions the innovation *begins*, and the discipline and the watchfulness *returns*.

2. Government intervention which may be necessary for humanitarian reasons in a *depression* can be counterproductive in a *recession* when an economy’s own restorative capacity is potentially at its strongest.

3. An avoidable drift from recession to depression may occur because recessionary adjustments have not been undertaken or assimilated in time. In the end it is obvious that the necessary institutional and economic adaptations will only be possible during severe *compulsive disordering* that typifies depression.

All the following messages from Business Cycles supplement that picture:

The pattern is well established. If -- the big if -- markets are dynamically competitive, recessions regularly work themselves out over shortish time frames by the recessionary process of liquidation (extinction and birth of firms). The danger is that recession turns into a vicious depression spiral of frozen credit, unjustifiable and unfair liquidations, violent drops in values, and unemployment as economies experience abnormal disequilibrium which for a time feeds upon itself because of declining demand, thrift, confusion, and the distorted expectations which arose during the prosperity. Depression and prolonged prosperity are ‘abnormal’. Innovation-led growth followed by recession is ‘normal’.

The pattern of credit during prosperity set the stage for recession. Debts are accumulated during prosperity, and recession is partly explained by the fact that the technological and commercial ventures required loans which were eventually (inevitably) overdone and unproductive. But things are worse because government policies including social welfare or subsidies to construction during prolonged prosperity inflate public debt and may also become direct incentives to consumer debt. Recession is more or less severe in proportion to the extent (and quality, one might say) of the overhanging debt. Pertinent today.

The usual pattern of revival after downturns is innovation, the opening of new investment opportunities, and institutional adaptation. Recessionary crisis performs the vital function of being both the signal and the compulsion for needed restructuring. It is the right time for harvesting fruits of the preceding prosperity. It is cheaper to introduce the new technology and to hire better brains in preparation for new innovations. It is a moment when the excesses, recklessness and creeping dishonesties of the preceding prosperity are tempered with renewed talk about moral codes in the banking community and about the valued bourgeoise traditions of business in general. Like it or not, it must be the time to eliminate “dead wood”. Some people and firms will fall off in the ensuing competition.

What about government’s role?

Schumpeter does accept government must intervene as a last resort if “pathological depression” takes hold. He would not have considered Europe or U.S.A. to be at that stage now. But under *no* circumstance is it right for government to engineer anticipation of recovery, postpone or prevent liquidation, and minimize the essential disturbance. That will dampen corrective behavior of firms struggling to find their own solutions to recurrent challenges. It would be consistent with Schumpeter’s observations to conclude that pumping money into an economy in or near recession creates the illusion that prosperity has been restored and weakens the incentives to make the necessary adjustments.

If investment incentives such as ease-of-entry-and-exit, taxation, and labour law are well aligned, firms can build capacity cheaply ahead of demand during recessions. Producers get accustomed to recurring shifts of demand and know how to respond. Government can help by ensuring the predictability of market rules and market-friendly policies. In order to avoid the *compulsive disordering* phase of depression the priority must be to allow the market system maximum flexibility to adjust during recession. Innovations that will take economy out of recession need room for maneuver and time to work themselves out.

Schumpeter and his unfashionable followers today emphasize institutional “lag” or “mismatch”. Corrections to the mismatch have historically occurred under extreme pressure during economic restructuring in cyclical recessions. Reform of institutions is government’s role, inevitably. That is where government should direct most of its energies during recessions/depressions. When one considers the importance of creative destruction in Schumpeter’s model, then logically a priority is to confront moral hazard and systemic risk head-on during recession. Obviously that means looking at the size of banks, perhaps regulating the deposit function as a utility, and bringing the shadow banking sector out of the shadows. The systemic risk in finance is greater now than in Schumpeter’s day.

As an economist Schumpeter focused on incentives. He combined history, statistics, and abstract theory. Schumpeter embraced mathematical modeling but cautioned against too much reliance on it. His principal contributions are not formal models. He had a capacity for straddling the social sciences which few economics have had. The world might be a safer place if more contemporary economists were trained to understand how incentives overlap at the intersections of economics, sociology, and politics. And they could be much bolder in their self-examination. They could go sit in the quiet courtyard and ask themselves -- Exactly why do I assume it is my job to think of ways to stabilize the economy? Exactly why am I falling into the habit of saying it is government’s job to create economic growth? And, why oh why do I impute fancifulness and a lack of consideration for humanity to any scholar who identifies the recurrent imperatives and logic of recessionary austerity?;