Tuesday, November 6, 2007

. Thomas K. McCraw. Prophet of Innovation. Joseph Schumpeter and Creative Destruction. Harvard University Press, 2007 [web page] [prologue] [interview] [podcast]

As Larry Kudlow used to say, Joseph Schumpeter is my favorite dead economist. We all know about the importance of the innovative entrepreneur. And we have all heard about "creative destruction", Schumpeter's "wonderful metaphor" (only second to Adam Smith's "invisible hand"). But somebody needed to put it all in context — a task at which Thomas McCraw excels like no other. Schumpeter led a very agitated life, constantly moving from one place to the other. He finally settled down at Harvard in the early 1930s. In sharp contrast to John Maynard Keynes' quiet life in England, Schumpeter's perpetual travels forced him to take a dynamic view of capitalism. The Keynes-Schumpeter rivalry is one of the most exciting elements of the book. From the perspective of the Global Liquidity Blog, however, I will concentrate on the parts that deal with money and credit.

Innovation & credit creation
Already in his Theory of Economic Development (1911), Schumpeter lays down the assumption that innovation implies the constant creation of ... credit. In a 1917 article, he emphasizes the role of money and credit in economic progress. As McCraw aptly puts it in the prologue:

The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures. From the Latin root credo —'I believe'— credit represents a wager on a better future. The entrepreneurs and consumers who make these bets often care little about the past and have scant patience with the present. They undertake innovative projects and make expensive purchases (houses, for example) that require far greater resources than those laying at hand. In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations (p. 7).

In a 1928 essay on "The Instability of Capitalism", published in Keynes's Economic Journal, he again focuses on the crucial role of credit. "Innovation", he writes, "being discontinuous and involving considerable change and being typically embodied in new firms, requires large expenditures previous to the emergence of any revenue. 'Credit-creation', therefore, becomes an essential part both of the mechanism of the process and of the theory explaining it". These large bets on the success of a new venture, McCraw adds, "can be lost completely if the venture fails". During the 1930s, Schumpeter struggled with what he called his "money book", a long treatise on money that was never completed. Instead, he opted for a monumental analysis of business cycles. And here's where things get really interesting.

Business Cycles
In his monumental Business Cycles (1939), Schumpeter analyses the dynamics of past industrial revolutions. He emphazises three key institutional innovations crucial to the rise of capitalism: "the factory, the corporation, and the modern financial system" (p. 254). The "railroadization" of the United States, beginning in the 1840s, is characterized by huge amounts of "credit creation":

Huge amounts of money flowed into the United States from Britain and Europe, through the purchase of railroad bonds and the use of overdrafts on banks (lines of credit). Some of these British overdrafts were granted 'with almost unbelievable freedom and carelessness'. In the United States itself, credit creation was often even more reckless — but it was also extremely innovative (p. 263).

The automobile industry was one of Schumpeter's favorite examples of capitalist growth. "In the invention of new financial techniques", writes McCraw, "the automobile industry was 'amost in a class by itself'. General Motor's introduction of installment buying created an immense amount of credit by turning consumers into significant borrowers ... With some many customers borrowing and repaying money to own a car, automotive manufacturers were able to minimize their own debts" (p. 267). There you have it. Right from the horse's mouth. Financial innovation follows business innovation: that's the good part. But euphoria leads to "freedom and carelessness" on the part of investors: that's the bad part. As I reflect on the current credit market mess, I can't help thinking: "We've been through this before. Big deal".

Are there any lessons to be learned from the book? I would point to the following:

[a] The "Great Moderation" thesis. From a Schumpeterian point of view, this notion does not make much sense. In contrast to Keynes' stagnationism, Schumpeter held the view that capitalism was no gentle process of adjustment but something more "like a series of explosions" (p. 255). [b] The US current account and liquidity conditions. Some commentators worry about the impact of an eventually declining U.S. current account deficit on financial innovation and liquidity conditions. Again, what drives financial innovation is ... business innovation. Don't worry about that one. [c] Economic growth and credit demand. Innovation and growth can occur without corporations having to raise large sums of cash. General Motors did it in the 1920s, and Apple is doing it right now. [d] Shorter cycles ahead? The more I read about business innovation, the more I am convinced that the process is alive and kicking: renewable energy, medical techniques, biosynthetics, Interet 2.0, etc. To me, that spells more, and shorter, cycles of euphoria and panic. And, yes, more financial innovation down the road.

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