The Skeptical Regulator*
Modest Observations on Regulatory Policy
Release 3.1 n January 2005

In an earlier essay, this skeptical regulator referred approvingly to the contributions in economic understanding made by Austrian economist Josef Schumpeter. [1] What did this man do and exactly what drives the "perennial gale of creative destruction" that he extolled? Why did Business Week call him "Today's Hottest Economist" and the Wall Street Journal has called him "the most important economist of the 20 th century? [2]

He is a figure from the past - dead now nearly three score years - and yet his shadow looms over technology policy questions more than Bill Gates or Steve Jobs. [3] Schumpeter's two most famous pronouncements were gloriously wrong and yet the essence of his work maintains a preeminent place in the ongoing exploration of how technology, markets and regulation intersect. [4]

Schumpeter is cited by Alan Greenspan as well as cabinet officials from both major parties. At the Federal Communications Commission, Michael Powell often referred to Shumpeterian forces in the telecommunications marketplace. Yet, one of Schumpeter's most important books included a detailed study of electricity markets.

In short, Schumpeter created and explained a useful new idea by testing the limits of economic theory. At the age of 27, while serving an Egyptian princess as a financial advisor, he published his second book, The Theory of Economic Development which introduces the vital role of the entrepreneur and innovation to economics. His work touched on a wide range of topics of interest to regulators today - monopoly power, non-rivalrous competition, innovation, business cycles - and near-always investigated disequilibria in the marketplace instead of the static models of competition which had dominated classical economics. To neoclassical economic concerns of allocative and productive efficiency, Schumpeter emphasized the importance of dynamic efficiency.

Perhaps overlooked, Schumpeter's economics is also closely tied to progress. In Schumpeter's world, the entrepreneur drives innovation and the gales of creative destruction are products of human achievement through which everyone's quality of life improves. Here, as elsewhere, Schumpeter placed technological change and innovation at the heart of economics.

Personal History and His Work

On January 8, 1950 - 55 years ago - Josef Schumpeter died. [5] Early in his career he was fond of telling people that his aspiration was to be "the greatest lover of beautiful women in Vienna, Europe's greatest horseman - and perhaps also the world's greatest economist." Later, he would mischievously claim to have achieved two out of the three objectives. [6]

Schumpeter married three times and at one time owned a stable of racehorses. During his lifetime, his many academic achievements were overshadowed by the reputation of Lord Keynes. Yet, the durability of his ideas and applicability of his insights to today's economic challenges call into question which of the three feats he failed to master.

The sweep of Schumpeter's academic contributions is grand. His posthumously published History of Economic Analysis (1954) was among the first to credit Christian scholastics for developing the scientific study of economics. His two volume Business Cycles (1939) picked up on the themes of innovation where the recently translated and re-released The Theory of Economic Development (1934) had left off.

Perhaps his most important contributions were collected in Capitalism, Socialism and Democracy (1942) for it is here that he explored the meaning and role of innovation as well as the weakness of static economic models.

For example, in this typical passage from Capitalism, Socialism and Democracy Schumpeter emphasizes the importance of dynamic change in capitalist societies.

The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process. It may seem strange that anyone can fail to see so obvious a fact which moreover was long ago emphasized by Karl Marx. Yet that fragmentary analysis which yields the bulk of our propositions about the functioning of modern capitalism persistently neglects it. [7]

A generation before the Chicago School emerged, Schumpeter acknowledged that markets were neither neat nor tidy. Efficiency is a useful concept but theoretical models do not describe many important aspects of how markets work. From these insights he savaged John Maynard Keynes for what he called the "Ricardian vice." [8] Keynes would reason in terms of abstract models where nearly all variables were held constant. Then he would argue that one of the few variables actually studied had caused the other in some direct fashion. The depths of this vice were achieved when a policy position was deduced from a highly abstract theoretical model. In this way, Schumpeter was a fellow traveler to Chicago School economist Ronald Coase and his later denunciations of "blackboard economics" for many of the same reasons.

In fact, his chief complaint about Adam Smith and other classical economists was their reliance on a static model of "perfect competition." Paramount to Schumpeter's thought is the "competition from the new commodity, the new technology, the new source of supply, the new organization... competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives." [9] It is from this idea that he argued that innovation creates a competitive pressure that is an "ever-present threat" that "disciplines before it attacks."

Competition for the market - and the temporary monopoly that successful capture of the market would produce - is perhaps more important for Schumpeter than competition within the market.

What is the source of all this newness? New competition, new ideas, new modes of organization were the result of the entrepreneur. It is entrepreneurs who break the crust of convention, leading the means of production along new avenues. [10]

Accordingly he delineated clear differences between mere invention and the more powerful innovation. [11] The latter category includes new means of production, new products and new sources of information that are the forces propelling the gale of creative destruction and incessantly tears at the fabric of current market positions. Entrepreneurial contributions obsolesce inventories, ideas, technologies, skills and business models. Therefore, the central question for economics is not "how capitalism administers existing structures,... [but] how it creates and destroys them." [12]

It was Schumpeter's 1939 book Business Cycles that clearly explained the breadth of innovation to include untraditionally studied sources of competition such as new supply sources or the development of new marketing, production or distribution methods.

Conclusion

Schumpeter's challenge to orthodox competition policy is profound. While antitrust and administrative regulation seek to constrain and prevent monopoly, Schumpeter says the quest for monopoly drives innovation and economic progress. [He thus laid valuable theoretic framework to justify the legal monopolies conferred by patents.] Therefore, in a dynamic market, Schumpeter would not merely endure but celebrate the appearance of innovation-driven monopoly.

For skeptical regulators, Schumpeter underscores the fallibility of static competition analysis. Static analysis misses the point and the resulting errors can be quite striking. Take for example the epic Justice Department case against IBM for monopoly over the market for mainframe computers.

Biographers and economic historians have noted the irony of Schumpeter's life and work. He was a gentleman scholar from a 19th century empire - advisor to royals and an equestrian - who was forced to adapt to the overwhelming changes introduced by 20 th century industry, warfare and academia.

Therefore it is no wonder that his enduring legacy is to direct our regulatory gaze toward dynamic efficiency, innovation and entrepreneurship. On that note, this skeptical regulator will give the irascible Austrian the last word of this epistle:

The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U. S. Steel illustrate the same process of industrial mutation - if I may use that biological term - that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. [13]

- The Skeptical Regulator

Next up for The Skeptical Regulator: Prices: What They Tell Us and How They Work

Footnotes

* The Progress & Freedom Foundation debuted The Skeptical Regulator in July 2003. The periodic essays are authored by president Raymond Gifford and other fellows at the Foundation. Send comments to regulator@pff.org

1. See, Raymond L. Gifford and Kent Lassman, "A Breakneck Tour: History of Thought in Economic Regulation," The Skeptical Regulator Release 1.1, August 2003. The essay can be found here.

2. Charles J. Whalen, "Today's Hottest Economist Died 50 Years Ago," BusinessWeek, December 11, 2000.

3. See for example various entries at http://blog.pff.org or more directly a monograph: Peter K. Pitsch, The Innovation Age, Hudson Institute and The Progress & Freedom Foundation, 1996.

4. Schumpeter famously began a prologue to a section of his Capitalism, Socialism and Democracy (1942) with the lines, "Can capitalism survive? No. I do not think it can." However, he was not a Marxist. His prediction was based on an internal condition of capitalist societies whereas Marx foresaw capitalism's demise from outside forces (such as a proletariat rising in opposition.) Schumpeter predicted that the success of capitalism would produce a type of corporation and fostering of values hostile to capitalism. This hostility would be especially strong among intellectuals who would make a living attacking the system of private property, capital and freedom necessary for capitalism. He feared the development of intellectual and social climate that would not allow entrepreneurship to thrive. Unlike Marx, he did not look forward to capitalism's end: "If a doctor predicts that his patient will die presently, this does not mean he desires it." To take the thought full circle, Schumpeter also wrote, "Can socialism work? Of course it can." Fortunately, while his prophesies have not been falsified, they have neither been proven true.

5. In 1883, Josef Alois Schumpeter was born in Trest, Austria-Hungary to parents who owned a textile factory. Modern borders place Trest in the Czech Republic. The year was auspicious for the economics profession, John Maynard Keynes was also born in 1883 and a well-established Viennese professor named Carl Menger published Investigations into the Method of the Social Sciences with Special Reference to Economics which gave rise to the " Austrian School " of economics with which Schumpeter and his teachers were later associated.

6. As a young man, Schumpeter enrolled at the University of Vienna to study law and economics and became a student of Eugen von Boehm-Bawerk and Friedrich von Wieser. He took a professorship in 1911 at the University of Czernowitz (now Ukraine ) and then in Graz where he remained until the end of World War I. During 1916-1917, Schumpeter was a self-described consultant to the Austrian Emperor and from 1919-1920 he served as Austria 's Minister of Finance. From 1920 to 1924, Schumpeter was president of the Biederman Bank. The rise of Hitler's Nazi party was the impetus for him to emigrate in 1932 from Bonn where he had been the chairman of economics since 1925. At that time he accepted a permanent position at Harvard where he taught until his retirement in 1949. In 1933 he was the founding president of the Econometric Society and in 1948 served as president of the American Economic Association.

7. Capitalism, Socialism and Democracy, p. 82.

8. One must assume that neither did Professor Schumpeter favor the economics of David Ricardo.

9. Socialism, Capitalism and Democracy, p. 84.

10. Josef Schumpeter, The Theory of Economic Development, Cambridge, Mass.: Harvard Univeristy Press, 1934.

11. Schumpeter's view on innovation explains one key difference between neoclassical and Austrian economists. Traditionally, non-price rivalry was viewed as a substitute for price competition. When firms did not exhibit price competition they would otherwise compete through advertising, product differentiation or innovation in the production process. Similarly, in regulated industries non-price rivalry is utilized to a significant extent as a surrogate because prices are legally held above the equilibrium level that would otherwise obtain. To Schumpeter, this misses the point. Non-price rivalry is a necessary complement to price competition.

12. Later economists in the Austrian tradition, such as Israel Kirzner, followed this insight and developed a rich vein of scholarship on the role of entrepreneurial activity.

13. Capitalism, Socialism and Democracy, p. 83.