Schumpeter’s Theory and Its Importance
Nowadays various scientists are searching for the explanation of the shifts of the economic boom to the economic downfall. The description of such changes was provided by Joseph Schumpeter in the fourth chapter of The Business Cycle. It is notable that the author does not just present his views concerning the causes and reflections of the economic shifts, but supports the ideas, provides the oppositions and counter-arguments to statements of other scientists.
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Schumpeter’s views are considered to be relevant in the 21st century, as they are widely used by modern researches for the investigation of various economic events in different locations all over the world. The examples and the outcomes of such studies will be provided in the final part of the paper. This essay gives the summary of Schumpeter’s ideas presented in the stated chapter, places them in the context of the whole work of the author and other researchers, and in the wider theoretic and historical context for the presentation of their relevance and applicability to the explanation of the economic events.
Joseph Schumpeter starts his work by providing his understanding of the psychology of crises that explains mistakes of frightened companies. Furthermore, he explains business fluctuations through a description of an objective chain of automatic causations. It should be noted, that the emphasis of the scientist on the studies concerning an economic crisis is closely connected with the historic events that precede the economic rises and downfalls, which take place in the late 19th and early 20th centuries. The examples of such events are industrial and social revolutions, rises of economies in European countries, the world crises during the post World War I and World War II periods, etc. The great importance of his work lies in the fact that he tries to explain the reasons and reflections of the past and current economic changes.
The scientist refutes the objections to his work provided by Loewe concerning the lack of description of periodicity of economic downfalls. Schumpeter notes that every economic rise is changed by depression, and states that no theory can determine the periodicity of these changes, as they are individual in each particular case (Schumpeter, 1982). The Schumpeter’s theory gives the general description of these alterations: the economic boom is changed by its downfall “after the passage of the time, which must elapse before the products of new enterprises, can appear on the market” (Schumpeter, 1982). Such general interpretation is rather overwhelming and relevant, because it enables the application of this idea to various economic collapses in different countries and time periods.
In the second chapter of his book Schumpeter states that the appearance of entrepreneurs is closely connected with the emergence of more beneficial economic conditions. He compares these concepts with the work of Speithoff, so as to make them more understandable by explaining the fluctuations of business. Both scientists agree to the existence of the alternating events, which give rise to the completely developed capitalism, and that the business conditions can be represented by the figure of the iron consumption, the beginning of causal nexus from the production of goods, and that the economic boom is facilitated by the increase of the capital investments. Unlike Speithoff, Schumpeter notes the considerable role of the purchasing power in the formation of the economy and states that “capital investment is not distributed evenly in the time, but appears en massive at intervals” (Schumpeter, 1982). Thus, Schumpeter has a distinct understanding of the causes of changes between economic booms and downfalls. In his turn, Speithoff considers these causes to be presented in the overproduction, existing capital and effective demand, when Schumpeter’s fundamental idea is reflected in the fact that the new companies are being created not from the existing ones, but alongside them. The relevance of this idea is based on the fact that it can explain not only the economic expansions caused by the industrial revolution and the development of trade, which takes place during the life of Joseph Schumpeter, but economic crises and booms that happen after his death in Europe, the USA, and other countries all over the world. Therefore, it proves that they can be elucidated by the analysis of the creation of the advantageous conditions for the establishment of new enterprises.
Schumpeter notes that the movement of the economy has a volatile character that is influenced by setbacks, counter-movements and various incidents connected with supply, demand, credit relations, etc. He mentions that the major feature of the disturbance is the panic, either influenced or not connected with the crisis, since both have a considerable impact on the whole economic situation. Thus, they are directly and circumstantially connected with the economy: wars of the 20th century, harvest, meteorological conditions, sudden abolishment of protective tariffs, etc. In addition, Schumpeter notes that crises are always formed under the influence of external events. He provides an example of how the economic difficulties in the country-investor can lead to a crisis in the country-receiver of funds, in other words, of how the outbreak of downfall in one place negatively influences the other. Nonetheless, the reasons and reflections of such downfalls are different due to various locations and fields, as they are caused by unique elements inherent to the latter. Consequently, it would be unjustifiesd to form some uniform laws or causes of crises.
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However, he marks that there are some general causes of changes leading to economic rises and downfalls that appear “discontinuously in groups” (Schumpeter, 1982). What is kore, the described changes tend to have inconstant character. This statement explains the fact that crises in the 20th century were not evenly distributed within the time period, as they were caused by sudden events depending on various locations of the world, like wars.
All in all, Schumpeter accepts the Juglar’s statement that the depression is caused by the prosperity, for the consideration of the economic downfall is either the reaction to the boom or the adaptation to it. This acceptance explains the differences between the ideas of Schumpeter and Spiethoff through the following: “the manner in which the boom leads to depression remains a thing by itself” (Schumpeter, 1982). The general economic downfall is inflicted by the simultaneous appearance of an abundance of problems within the new enterprises. In contrast to Spiethoff and Mitchell, Schumpeter does not consider that unemployment and stock of materials can explain the crisis, as these factors can be neglected for the determination of the nature of economic shifts.
Conceptually, the simultaneous appearance of new companies occurs due to the following factors: the vast majority of new combinations, massive entrepreneurial demand connected with the increase of the purchasing power of business (secondary wave), and general mistakes that influence the whole economy (Schumpeter, 1982). The second factor, which is more important for the theory of business indices, reflects the situation when the appearance of several entrepreneurs facilitates the emergence of the new ones. Subsequently, the chapter II of the book states the idea that new combinations can be developed only by people who have some managing qualities. Hence, these people set the direction in a particular cluster in order to overcome and destroy the existing barriers. Others can follow their examples without the necessity to manage the similar difficulties. Afterwards, such qualities are distributed over the society, thus making the process of establishing the new companies easier and faster, and facilitating the spread of prosperity through the rise of capital investments, growth of the purchasing power, reduction of the unemployment and increase of wages. In such way numerous economic processes are developed without any close connection with the real driving force: entrepreneurs who set direction will be more qualified than people who follow their example, so the boom would start in one cluster and spread over the other fields of economy. Hereby lies his explanation of how the technical innovations, which were developed in the beginning of the 20th century, facilitated the economic boom in the European countries.
The continuous appearance of entrepreneurs causes disturbance and the necessity of adapting to them. It facilitates the process of liquidation, known as “an approach to a new statistic state” that reflects the struggle of the economic system towards new events that causes periodic depressions (Schumpeter, 1982). This process can be explained by the fact that the entrepreneurs’ demand leads to increase in prices and competition between the old and new products (Schumpeter, 1982). The first reason is based on the understanding that the innovations and the establishment of new enterprises require additional investments. The simultaneous appearance of the considerable amount of new products leads to lowering of prices, credit deflation and credit restriction by banks, termination of the economic boom, further depression and crisis. Such negative consequences cause panic, especially on the side of weaker entrepreneurs. Schumpeter emphasizes that the “boom itself creates an objective situation, which easily leads to crisis or a depression, position of relative steadiness and absence of development” (Schumpeter, 1982). These ideas explain the lowering of entrepreneurial activity, stagnation of production and industries, and fall of the barometers of their performance, as the iron consumption and unfilled orders of the US Steel Corporation. As a consequence, the downfall in one particular industry affects the whole economic system.
Although Schumpeter describes causes, stages of formation, reflections and consequences of depression, he also identifies the reasons that may prevent it: anticipation in unequal degrees and the lowering of capital investments that leads to a decrease of the activity of entrepreneurs, and the stagnation of the industry. Schumpeter notes that often economic downfalls can be recognized as per their secondary characteristics. Thus, he enables readers to determine the crisis before it becomes apparent, because the negative outer factors, the uncertainty and the possibility of unpredicted losses have a considerable influence on entrepreneurs, forcing them to take wrong decisions, which lead to further problems. The overproduction is considered to be the consequence of the skewness of the economic rise that happens due to discrepancies between effective supply and demand caused by the loss of equilibrium of the economic system. The scientist notes that it has a different effect on old and new companies, as older entrepreneurs have some reserves for overcoming the downfall, which may include strong business relationships, or support of financial institutions, etc.
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In addition, the author states that the depression causes not only negative events, as it facilitates the establishment of the new equilibrium position in the economy: as when forced to adapt to the conditions of the economic downfall people become focused on developing new business-combinations and production. In such instances, an old business has several possibilities for the further movement: inability to adapt to new market conditions and decay; surviving in more modest position; and shifting to another industry or use new technologies for lowering the cost of production. Schumpeter’s ideas may be relevant for entrepreneurs as they would help them anticipate and adapt to the coming economic shifts. Furthermore, some outer factors, as good harvest, can help business minimize the negative reflections of economic fluctuations. All in all, he states that “there must always be a process of absorption between two booms” for the explanation of the cycles of the economic states and for completion of the provided arguments (Schumpeter, 1982). The process reflected in the downfall provides the fulfillment of the promises made by the economic rise through increasing the stream of commodities, reorganization of production, diminishing of its cost and growth of the permanent real incomes of the representatives of other classes (except entrepreneurs) (Schumpeter, 1982). Therefore, the economic downfall merely reflects the procedure of exploiting the possibility of profit and bringing resources to various individuals. Schumpeter also notes that participants with fixed money incomes obtain numerous benefits from the economic downfall as the commodity content of their incomes expands.
Common workers face the increase in the demand of their labor and the consequent rise in wages during the periods of the economic boom, which facilitates the growth of their income and their ability to purchase more goods. Such increase in the demand of consumption leads to the rise of the general price level. In its turn, the development of new ideas and the establishment of new companies lead to the rise in the demand of the previously unemployed workers. However, some entrepreneurs prefer to increase automatization of their production for the minimization of the amount of workers and it leads to the technological unemployment. Hence, Schumpeter reveales the reasons why numerous people became unemployed due to the technological progress in the 20th century. Such “new combination shifts the relative marginal significance of labor and land, which was obtained in the old productive combinations, sufficiently to the disadvantage of labor” (Schumpeter, 1982). It explains the way the economic nature of the downfall reflects the diffusion of the achievements of the economic rise over the whole system through the mechanism of adaptation in order to return into the state of equilibrium.
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Schumpeter stands in the opposition of the following doctrine developed by Keynes, Fisher and Hawtrey: “neither profits in a boom nor losses in a depression” (Schumpeter, 1982). As. According to him, the crisis accompanied with the associated panics and uncertainty form the beneficial environment for the abnormal course of events, and lead to unpredicted situations causing new disturbances. Nonetheless, the negative consequences of the economic rise and downfall can be minimized in various ways. For instance, it can be accomplished by improving the prognosis about the business cycles through mitigation of the consequences of the swarm-like appearance of new combinations, entrepreneurs, and the reflections of the further depression. Additionally, the amount of unadoptable businesses should be lowered by means of the financial regulations. Nonetheless, such regulations could not influence the economic and social processes and related changes, which are much more important than the economic stability.
The Influence of the Theory
Schumpeterian description of business cycles has a considerable influence on the works of Ondrej Tichy, where he examines the contemporary types and searching of new innovation approaches using the framework developed by Joseph Schumpeter (Tichy, 2011). The author tries to predict the next wave of the economic changes that would occur in the 21st century in order to perform some actions to be able to take advantage of them. Ondrej Tichy in his studies reveals that the next economic wave would be closely connected with information and communication technologies. This idea is based on extensive research which foresees the technological upswing in the nearest future and supports it by the following Schumpeter’s statement: “some innovation has been successfully carried into effect, the next wave is much more likely to start in the same or a neighboring field that anywhere else” (Tichy, 2011). In broader perspective, Schumpeter’s ideas reflected in Tuchy’s studies interpret the possible economic growth based on the present technological revolution.
The Schumpeter’s prediction concerning the fact that investments can have a positive effect in the form of optimization of the economic growth stipulated Nayia Mahajan and Satih Verma to study Indian financial development in the recent years. The authors analyzed whether the improvement of the Indian financial sector contributed to the rise of the economy in the country. As a result, they disclosed a “long run equilibrium relationship” between the positive changes in the financial system and the growth of the economy (Mahajan & Verma, 2014). Therefore, their work proves that Schumpeter’s ideas can be applied not only to European or American economic events within the 20th century. These ideas provide the explanation for the conditions, which facilitate economic development in countries located in different parts of the world
The ideas provided by Schumpeter have also influenced the research of John Silvia and Azhar Iqbal (2011) who studied the U.S. profit changes in their work. The authors investigated a mean-reverting behavior of the profit growth, the volatility of profits, and their vulnerability in certain periods of time. John Silvia and Azhar Iqbal (2011) based their investigations on Schumpeter’s idea that the deviation of circumstances and profits can change the nature of the economic equilibrium. The outcomes of their research were consistent with the scientist’s view “that is, profit growth is mean-diverting with a possibility of deviation from long-run trend growth” (Silvia & Iqbal, 2011). That means that the concepts presented by Schumpeter contributed to the investigation of the influence of profit by the authors through the use of real life examples of the downfalls and rises in the American economy.
In conclusion, it should be noted that the current work provides the general overview of the Schumpeter’s ideas stated in one of the chapters of his book. The scientist claims that the economic rise after the passing of the time necessary for elapsing of the production of new companies shifts to the economic downfall. Moreover, Schumpeter supports the ideas of other authors (like Speithoff) regarding the great role of the purchasing power and prosperity in the formation of the economic cycles.
He also states that the rise in the economic cycle is closely connected with the appearance of new entrepreneurs alongside the existing companies, the production of new goods, and making new mistakes, which lead to the economic downfall. Although its mitigation is influenced by the unpredicted events, the author proves that the rise of the crisis in one sphere leads to the downfall of other spheres due to their interconnection. Schumpeter notes that these crises and economic downfall serve as the reaction on the boom, and reflect the economic adaptation to changes with a view to overcome the possible appearance of problems in the new enterprises. Such negative reflections of the downfall can be mitigated by making thorough economic predictions even though they obtain some advantages reflected in the establishment of the new equilibrium position of the economy and creation of new entrepreneurs. Schumpeterian description of business cycles has considerable influence on the studying of various factors that are closely connected with the economic cycles: innovations, improvement of the financial system, and behavior of profit growth. The further research can be explore the description of the economic cycles in different countries, or explain other factors that influence these cycles.