Economic debate is missing a beat

This is my latest Perspective column for Fund Strategy.

One of the unexpected side effects of the economic crisis is to turn prominent dead economists into rap stars. A video featuring a rap battle between John Maynard Keynes (1883-1946) versus Friedrich August Hayek (1899-1992) has received over 2.8m hits while the sequel has garnered 1.3m.

The rap videos embody the two sides in contemporary economic debate. At times of crisis, Keynesians typically favour low interest rates, along with public spending to boost demand. Hayekian free marketeers fear that such measures will stoke runaway inflation. In practice Keynesian prescriptions are generally favoured, although that does not necessarily mean they will be proven right in the long run.

However, it would be wrong to see economic debate as limited to these two viewpoints. On the contrary, the focus on Keynes and Hayek illustrates the narrowness of the contemporary discussion. There are other important voices who represent radically different outlooks and policy alternatives.

A key figure is Joseph Alois Schumpeter (1883-1950), a former Austrian finance minister who later became a professor of economics at Harvard. Alan Greenspan, later to become chairman of the Federal Reserve, was one of his many students to attain eminence.

Schumpeter advocated the view that capitalism needs regular restructurings for it to survive. For him recessions represent a cleansing process in which old businesses and technologies perished while new ones flourished. Although his name features little in the mainstream policy debate on the crisis he is widely quoted in the discussion of innovation.

Schumpeter’s concept of how capitalism regenerates itself through restructuring is embodied in his concept of “creative destruction”. In his Capitalism, Socialism and Democracy, first published in 1942, he argued that: “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.”

As Joseph Stiglitz, who won the Nobel prize for economics in 2001, points out in a new edition of the book this view directly contradicts that of mainstream economics. Most contemporary economists see capitalism as existing in a state of competitive equilibrium. In theoretical terms this is often referred to as the Walrasian model or the Arrow-Debreu model.

For Schumpeter, in contrast, capitalism should be seen as an evolutionary process. It continually restructures itself through innovation and recessions. He acknowledges that this is, at least in part, a destructive process but he argues it is necessary: “Progress entails … destruction of capital values in the strata with which the new commodity or method of production competes.”

It follows from Schumpeter’s argument that the restructuring process under capitalism needs to be allowed to happen – an eventuality that contemporary politicians seek to avoid at all costs. From this perspective the boom and bust cycle should be embraced rather than feared. He does temper his views by conceding there is room for measures to avoid obsolescent industries “coming down with a crash”.

A further twist to the tale makes Schumpeter’s argument even more extraordinary. Although he was a staunch political conservative he acknowledges that his notion of progress through innovation is derived from Karl Marx (1818-1883). “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.”

Schumpeter saw Marx as a flawed genius whose great insight was in understanding the process of progress through innovation under capitalism. The first four chapters of Schumpeter’s 1942 work deal with different aspects of Marx’s thought. The 20th century economist was keen to distance himself from Marx’s politics, philosophy and sociology while appropriating what he regarded as the socialist thinker’s great economic insight.

So in Schumpeter’s hands the theory of what he called creative destruction is denuded of its revolutionary content. The hero of his narrative was the entrepreneur who he saw as the main agent of progress and innovation under capitalism. This is in sharp contrast to Marx’s view of the proletariat as the potential bearer of revolutionary transformation.

It would be a grave mistake to dismiss this discussion as an archaic spat between two dead white economists. If the concept of creative destruction is correct, it has huge implications for contemporary economic policy. It suggests that attempts to head off crisis by extending credit are likely to be counter-productive in the longer term. Such measures only postpone the need for capitalism to undergo a much needed cleansing process.

It is impossible to say exactly what policies the long dead would have advocated but the idea of capitalism as a process suggests a tougher line on bail-outs. As Martin Wolf, the chief economics commentator of the Financial Times, said at the recent Battle of Ideas conference in London: “Letting the banks collapse sure as hell would have been Schumpeterian.”

Recent history does seem to indicate that extending credit, either through high public spending or low interest rates, only succeeds in creating more bubbles. From this perspective the current crisis can be seen as the culmination of several attempts to postpone restructuring. Eventually such measures simply led to the inflation of an even bigger bubble which has burst with even more damaging results.

Policies based on the view of the market economy as a static system do not seem to work in practice. In Schumpeter’s words, “a theoretical construction which neglects this essential element of the case neglects all that is most typically capitalist about it; even if correct in logic as well as in fact, it is like Hamlet without the Danish prince.”