Title: Prophet of Innovation: Joseph Schumpeter and Creative Destruction
Author: Thomas K. McCraw
Scope: 3 stars
Readability: 4 stars
My personal rating: 4 stars
See more on my book rating system.

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Topic of Book

The author writes a biography of economist Joseph Schumpeter and his works.

Key Take-aways

• Joseph Schumpeter is one of history’s most important and approachable economists.
• Schumpeter helped popularize concepts such as creative destruction, the business cycle, entrepreneurship, business strategy and innovation.
• Schumpeter attacked the economists’ assumption of perfect competition. He argued that mature industries were dominated by oligopolies, which made them vulnerable to innovation by entrepreneurs who form new companies.
• Schumpeter worried that the very success of capitalism would undermine its popular support, leading to socialism.

Important Quotes from Book

This biography, by necessity, has two protagonists: Joseph Alois Schumpeter (1883–1950) and the phenomenon of capitalist innovation. Schumpeter was one of the greatest economists who ever lived, and an electrifying personality besides. The study of capitalism obsessed him.

Schumpeter’s work was so powerful that today’s thinking about capitalism is in large part his—specifically, his emphasis on innovation, entrepreneurship, business strategy, and “creative destruction.” Specialists in the analysis of business identify him closely with the first two of these terms. He helped to popularize the third, and he coined the fourth himself. Schumpeter was to capitalism what Freud was to the mind: someone whose ideas have become so ubiquitous and ingrained that we cannot separate his foundational thoughts from our own.

“Creative destruction is the essential fact about capitalism,” he wrote. “Stabilized capitalism is a contradiction in terms.”

“A society is called capitalist if it entrusts its economic process to the guidance of the private businessman. This may be said to imply, first, private ownership of nonpersonal means of production . . . second, production for private account, i.e., production by private initiative for private profit.” He went on to say that a third element is “so essential to the functioning of the capitalist system” that it must be added to the other two.

This third element is the creation of credit. The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures.

The entrepreneur, Schumpeter once wrote, is “the pivot on which everything turns.” Entrepreneurs—whether they operate in big firms or small ones, old companies or startups—are the agents of innovation and creative destruction. Their projects are the wellsprings of new jobs, higher incomes, and general economic progress. But in releasing their creative energies, rising entrepreneurs shove older ones aside, destroying their dreams and often their fortunes.

But if capitalism can somehow be brought into balance with nobler human purposes, it becomes the economic equivalent of Churchill’s famous definition of democracy: the worst possible system except for all the others. For despite its flaws, capitalism alone has fostered the scientific, technical, and medical innovations necessary to lift humanity out of a Hobbesian state of nature, where life is solitary, poor, nasty, brutish, and short.

Hundreds of first-rate thinkers have grappled with these issues. Two of the very greatest, Adam Smith and Karl Marx, came to opposite conclusions. Smith (1723–1790) saw the market economy as a nearly ideal system, whereas Marx (1818–1883) denounced it as an unpleasant interval on the inevitable path to socialism. Schumpeter, born late enough to study capitalism in its twentieth- century maturity, surpassed both of his more famous predecessors in analytical sophistication.

The most striking fact about capitalism, therefore, aside from its economic efficiency, is its late appearance. Why did it take so long to arrive? Once it did emerge, why was it so widely resisted for so many years? And why do so many otherwise intelligent people in so many parts of the world still fight against its adoption? Why would they rather be ruined than changed?

He already knew, or was soon to discover, that the patterns of pre-capitalist society reflected some very deep-seated human values and traditions:

A conviction that spiritual life suffered grievous damage if people became immersed in materialism.

The absence of belief in upward social and economic mobility.

No widespread sense of personal freedom and individual autonomy.

The governance of most occupations and crafts by cartels (agreements to divide markets and keep prices high) and guilds (exclusive associations of craftspeople).

A primitive financial system that lacked paper money, stocks, bonds, or any other credit mechanism.

The absence of the two pillars that support all successful business systems: a modern concept of private property and a framework for the rule of law.

Toward the end of his life, Schumpeter issued a remarkable credo about the primacy of history. Of the three basic building blocks of economics—theory, statistics, and history—he wrote that the last “is by far the most important.”

Only three years after the relative failure of Business Cycles, Schumpeter made a spectacular recovery, publishing in 1942 the most popularof all his works, Capitalism, Socialism and Democracy… The book contains one of the most perceptive analyses of capitalism ever written.

He poses three momentous questions:

First, is capitalism, by its own nature and process, doomed to failure?

Second, if socialism replaces capitalism, can it produce comparable economic success?

Third, is democracy likely to accompany either system?

He begins his argument by demonstrating that modern industrial capitalism has produced the greatest per capita output of goods ever recorded. And, in direct contravention of the Marxian forecast that workers’ share of income will steadily fall, Schumpeter repeats that “relative shares have substantially changed in favor of the lower income groups.”

In Capitalism, Socialism and Democracy, Schumpeter next mounts a spirited assault on the idea of “perfect competition.

Perfect competition lends itself very well to mathematical modeling, however, and that advantage has been almost irresistible to economists. But because it neglects the dynamics of creative destruction, Schumpeter finds perfect competition wholly unsuitable for understanding a modern capitalist economy. When, for example, a new product or process is introduced, all buyers and sellers cannot possibly have complete information about potential markets.

Schumpeter underscores the deficiencies of any conceptual system that proceeds from perfect competition and static assumptions.

Instead, much of modern business in advanced industrial countries has evolved into a form of organization known as “oligopoly…  It now refers to industries in which a small number of large and powerful firms compete with one another in the same line of business: oil, steel, automobiles, chemicals, and a few others. Most of these companies are engaged in mass production, mass distribution, or both; and they often require very large capital investments. In oligopolies, Schumpeter writes, “there is in fact no determinate equilibrium at all.

Schumpeter then returns to the question of monopoly, mounting an attack on many Americans’ mistaken idea that monopoly and big business are the same thing. But under modern capitalism, long-run cases of monopoly are almost nonexistent— even rarer than instances of perfect competition. Hence, high entrepreneurial profits are always temporary. And on balance, big business is unquestionably a positive force for innovation and growth.

It seemed plain to Schumpeter that continuous technical innovation and organizational remodeling, not monopolistic profits, accounted for the prosperity of most great companies.

The case for capitalism, says Schumpeter, “must rest on long-run considerations.” In the short run, it is impossible for people generally, and even intellectuals, to ignore what seem to be unreasonable “profits and inefficiencies.” They therefore have difficulty in seeing long-range trends in which capitalism is benefiting society as a whole. Uniquely among economic systems, therefore, capitalism “creates, educates and subsidizes a vested interest in social unrest.” With its bountiful production, it underwrites the education of a class of hostile intellectuals who have no “direct responsibility for practical affairs” and little experience in managing anything.

Schumpeter’s signature legacy is his insight that innovation in the form of creative destruction is the driving force not only of capitalism but of material progress in general. Almost all businesses, no matter how strong they seem to be at a given moment, ultimately fail—and almost always because they failed to innovate. Competitors are relentlessly striving to overtake the leader, no matter how big the lead. Responsible businesspeople know that they ignore this lesson at their peril…  They are “standing on ground that is crumbling beneath their feet.”

Only through innovation and entrepreneurship can any business except a government-sponsored monopoly survive over the long term. Schumpeter, of course, is the chief proponent and popularizer of the word “entrepreneur.”

If you would like to learn more about the role of innovation in creating economic growth, read my book From Poverty to Progress.