Book Review: The Theory of Economic Development by Joseph Schumpeter

Joseph Schumpeter is known as the “Prophet of Innovation” and published his work The Theory of Economic Development at 28 years of age (1). As an economist he didn’t receive much attention because he wasn’t in alignment with the popular Keynesian Economics of the time (2).  His greatest achievement being the meshing of sociology with economics to make a system of development.

The chapters of the book are:

(I) The Circular Flow of Economic Life as Conditioned by Given Circumstances;

(II) The Fundamental Phenomenon of Economic Development;

(III) Credit and Capital;

(IV) Entrepreneurial Profit;

(V) Interest on Capital;

(IV) The Business Cycle.

Schumpeter believed in a perfect equilibrium where there are no profits, no savings, no new products, no voluntary unemployment, or need. It is a system of economic flow where there is no need to adapt, adjust, or change because everything is running smoothly. This perfect equilibrium either never existed or only exists for a short time before the system changes again.

The economic system is forever in constant flux. It is being destroyed and rebuilt to adapt to new situations. Combinations occur to help solve economic problems through the use of innovation. As a system adjusts it must then readjust through innovation. This innovation pushes the system to new heights.

Entrepreneurs are the catalyst to change. When they innovate a new product or service it forces the system to adjust again. Entrepreneurs rely on credit and must be productive to pay that credit effectively. Their production encourages copycat adaptations not only in the field in which the product was produced but also in other fields as well leading to wider innovations that further the system.

As products become adapted they will naturally experience a reduction of value as the market becomes saturated. This saturation offers a lower return on investment and in turn forces companies to innovate the product again. Failure to innovate the product means that companies cannot pay their loans or earn profits. Capital must be available to start anew.

In this book I find three main concepts of significant importance 1.) Sociology as part of the economic system, 2.) A flow of interconnected elements and 3.) Combinations. To me economics is about fulfillment of human need and when it fails to fulfill human need the economic system collapses and changes. Schumpeter touched upon the wider impact of disruptive technology that forces related components to adjust and reshape themselves within the market. Finally, combinations is literally the combination of one idea to the next even though it is seen in the Schumpeterian model as the combination of physical elements to create new products.

Beyond Schumpeter we find that societies are contracts between the governed and those doing the governing. All systems must allow for the manifestation of knowledge and motivation for maximum growth. When political, economic, or legal systems block that effort the system starts a slow decline. That system should encourage effort among the masses to speed up the economic elements and allow for the combinations of thought to be realized as the combinations of physical elements in the creation of new products and services. Maximum freedom in human effort should be encouraged beyond that which is necessary to protect the system, the people within the system or the environment in which they live.

Saving or Spending for Economic Growth?

Neoclassical growth theory states that higher saving rates can increase long-term wealth while Keynesian economics indicates that higher saving rates can lower consumption. Yun-Kwong Kwok in his paper creates a bridge between the two theories by studying the links of the Solow diagram (neoclassical) and IS-LM curves (Keynesian).  These two concepts are often covered separately in college because they do not easily mesh into a single framework.  People are left wondering if we should save or spend?

The first concept to understand is that the neoclassical model is a long-term model while the Keynesian model is more short-term.  One focuses on a longer-term trend while another focuses more on immediate needs. This is one reason why decision-makers who are looking for immediate results often use the Keynesian model. 

In the long-run Solow model, the total output Y of an economy is produced by capital K and labor L: Y=F(K,L).  Capital accumulates through net investment. Output is absorbed through consumption. Stability occurs when accumulation and consumption match. Standard of living improves to match total accumulation until the system is equal in inputs and outputs. 

An assumption of the Keynesian model is that when prices and wages are flexible the economy will be at full employment. Because prices are sticky, the economy deviates for a period from full employment. When demand for certain products produced by a country declines, so will the employment rate. In other words, you cannot keep producing if no one is buying and that means lay-offs and higher unemployment. 

The author found that an increase in the savings rate will first lead to short-run recession but will eventually create long-term growth. He argues that as the central bank increases the money supply it will decrease the interest rate and increase output. A recessed economy with cash infusion will move toward its long-run potential. If that potential is high then it can create benefits. However, an infusion of money that is working against a poor long-run potential will cause prices to increase and output, consumption, and investment to decline. Policy makers must understand the positive or negative long-term potential to determine if infusion, infrastructure improvements, or other policies will result in higher growth.

Comment: It would appear that a major miscalculation is the long-term productivity of the economy. When an economic system loses its fundamental competitive nature through not keeping up with worldwide competition an increase in debt/liquidity during a recession may improve the short-run situation but damage long-term growth through greater debt servicing expenses and lower productivity.  Yet it is a well-known tool that is easy to use and grab when situations become difficult. The question becomes what do we do with this debt once we get back to a normal economy that cannot afford to service it? Creating sustainable systems that continuously reinvest parts of their working capital and saves a percentage of their profits from lower transaction costs (improved profits) through infrastructure improvements allows for greater cash infusion with long-term liquidity and investment prospects. The problem we face is knowing which infrastructure improvements will raise business prospects, tax capital, and business investment. Since businesses work in an infrastructure platform improvement upon that platform raises their opportunities for success but needs to be done in a fiscally responsible manner. Doing so in a smaller hub allows for the proper experimentation for national policy development. 

Kwok, Y. (2007). To save or to consume: linking growth theory with the Keynesian Model. Journal of Economic Education.

Economic Systems Grow Through Sustainable Reinvestment

Business and cities exist together and follow similar stages of growth and decline. Each invests back into itself to foster higher levels of economic interaction and revenue development. Governments seek to create a net return on tax investments while businesses seek revenue returns on new product/service lines.  Without constant reinvestment and growth, the system eventually declines. 

Sustainability can be seen as a positive return on investment money that allows for reinvestment back into the system for future growth. Governments may reinvest resources in schools, roads, police, WI-FI, fiber optic cables, etc. to realize greater levels of income generating interactivity. The basic development mechanics between business and government are similar even though they take different forms.

Economic hubs must draw in resources to fuel future growth. Resources may come in the form of new business start-ups or existing corporate reinvestment. Private investment increase local revenue streams that raise tax revenue (not tax rate) and create more tax paying employment opportunities (not tax rate). Growth can be seen as the total increase in economic activity and revenue development throughout the hub. 

Young governments and business entities may grow quickly but will eventually move into a mature stage when they reach homeostasis with the market. During this mature stage, a consistent percentage of revenue should be reinvested back into their systems to maintain future growth. This reinvestment ensures that the system continues to develop, improves the lives of its residents, lowers transactional costs, and attracts new investments. 

 When a system is not sustainable, or fails to reinvest back into itself, it declines. The system may begin to lose residents, raise taxes, fail to attract businesses, take unnecessary debt or fall behind on needed infrastructure improvements. Eventually the system may need to painfully revamp itself, seek outside assistance, or perish into history as resources disinvest and make their way into better-managed systems.