07 May 2007  Research & Ideas

Rediscovering Schumpeter: The Power of Capitalism

Economist Joseph Schumpeter was perhaps the most powerful thinker ever on innovation, entrepreneurship, and capitalism. He was also one of the most unusual personalities of the 20th century, as Harvard Business School professor emeritus Thomas K. McCraw shows in a new biography. Read our interview and book excerpt. Key concepts include:

  • Schumpeter's ideas on capitalism, entrepreneurship, and innovation still have great resonance to students and businesspeople today.

 

If capitalism was the most influential single economic and social force of the 20th century (and continuing today), there is no better guide to understanding its power and complexity than famed economist Joseph Schumpeter, says Harvard Business School's Thomas K. McCraw. “I think Schumpeter is the most penetrating analyst of capitalism who ever lived. He saw things other people didn't see.”

McCraw, a past winner of the Pulitzer Prize for History, has written a new biography, Prophet of Innovation: Joseph Schumpeter and Creative Destruction, which weaves together threads of social, business, and economic histories to illuminate Schumpeter's life and work. A central theme details how Schumpeter's insights help us understand how the forces of capitalism, innovation, and entrepreneurship continue to transform the world today.

Making the story even more compelling is Schumpeter's charismatic personality. Something of a dandy, Schumpeter (1883-1950) was a hit with women, adored by students, and both made and lost a fortune in a matter of years. He also once initiated a sword fight with a librarian—and won.

McCraw, the Isidor Straus Professor of Business History Emeritus, discusses his research and thoughts on Schumpeter's legacy in this e-mail interview.

Sean Silverthorne: What attracted you to research and write about Schumpeter? And why the title Prophet of Innovation?

Thomas McCraw: I first encountered Schumpeter many years ago, as an undergraduate, and I've enjoyed reading his works ever since. But the main reason I wrote this book is the tremendous resonance his ideas have had with my HBS students and with businesspeople.

I think Schumpeter is the most penetrating analyst of capitalism who ever lived. He saw things other people didn't see, partly because he lived in 7 different countries. He also served briefly as Austria's finance minister and worked for 3 years as an investment banker, where he made a fortune that he promptly lost in a stock market crash. So he wasn't a typical academic, even though he spent most of his career as a professor, including almost 20 years at Harvard.

As for my title, here's the quotation that inspired it: "Without innovations, no entrepreneurs; without entrepreneurial achievement, no capitalist returns and no capitalist propulsion." Schumpeter wrote this sentence during the Great Depression of the 1930s. Many, many smart people of that time believed that technology had reached its limits and capitalism had passed its peak. Schumpeter believed the exact opposite, and of course he was right.

Q: Schumpeter introduced the term “creative destruction” and championed the role of the entrepreneur in both start-ups and in established companies. What can business leaders take away from his development of these ideas?

A: The main takeaway is the absolute relentlessness of creative destruction and entrepreneurship. In a free economy, they never stop—never. Schumpeter wrote that all firms must try, all the time, "to keep on their feet, on ground that is slipping away from under them." So, no serious businessperson can ever completely relax. Someone, somewhere, is always trying to think of a way to do the job better, at every point along the value chain. Whatever has been built is going to be destroyed by a better product or a better method or a better organization or a better strategy.

Schumpeter believed the exact opposite, and of course he was right.

This is an extremely hard lesson to accept, particularly by successful people. But business is a Darwinian process, and Schumpeter often likened it to evolution. The creative destruction can occur within a large innovative company (Toyota, GE, Microsoft), but it's much more likely to happen with start-ups, particularly since they now have so much access to venture capital. Schumpeter, by the way, was one of the first economists to use that term. He wrote an article in 1943 in which he speaks of "venture capital."

Q: Capitalism, Socialism and Democracy is perhaps Schumpeter's best-known work. What makes it so rich and provocative even half a century later?

A: Chapter 7, "The Process of Creative Destruction," is only 6 pages long, but it perfectly captures the essence of capitalism. The 2 chapters preceding and the 2 following it flesh out the argument. So in the space of a little more than 40 pages, we have probably the richest material ever written on the broad subject of capitalism. The rest of the book is full of provocative ideas on politics, economics, and society, from ancient times to the present.

Schumpeter wrote some parts of the book in the form of satire. In his long analysis of socialism, for example, he seems to be arguing that it is a superior system. But this whole section is really an elaborate shell game. As Jonathan Swift, the greatest satirist writing in the English language put it, "Satire is a sort of glass wherein beholders do generally discover everybody's face but their own." Some readers actually came away from Schumpeter's book believing that he was a socialist. In fact, he was one of the most ardent defenders of capitalism of his time. But he was very subtle about it, trying above all to force his readers to think for themselves.

Q: You compare reading his books with listening to Beethoven's symphonies. What powers did Schumpeter command as a writer?

A: I made this comparison for 2 reasons. First, Beethoven's music is not always easy to understand—in contrast, for example, to Mozart's. (Mozart is the most widely recorded of all classical composers, and Beethoven second.) You have to be patient with Beethoven, and listen very carefully, sometimes over and over, to get the full message.

Another reason for the comparison is that Beethoven's music is grandiose and extremely romantic, and the same can be said of Schumpeter's writing—very unusual for an economist. But because capitalism is much more than just an economic system, Schumpeter made himself more than an economist. He was the most erudite economic scholar of his time, and perhaps of all times.

Q: Today, what would Schumpeter tell us about the evolution of capitalism in the 21st century?

A: Several economists, including Larry Summers and Brad DeLong, have said that the 21st century is going to be "the century of Schumpeter," and I agree. The reason is that innovation and entrepreneurship are flowering all over the world in unprecedented fashion—not only in the well-publicized cases of China and India, but everywhere except those areas that foolishly continue to reject capitalism.

The word "globalization" is accurate enough, but if anything it understates the case, in part because of the information revolution wrought by the Internet. This situation makes management harder and more challenging than it's ever been before. As a historian, I don't say that lightly.

Q: Schumpeter was a fascinating personality—a womanizer, incredible intellect, great teacher. And how many prominent economists have provoked a sword fight with a librarian? But at the same time, as your biography illustrates, Schumpeter could sink into self-doubt. What are your personal feelings toward the man? Did your impressions of him change while writing the book?

A: One of the joys of writing this book was dealing with Schumpeter's personal life. I knew it was going to be interesting, but not nearly so much as it turned out to be. His student Paul Samuelson, the first American to win the Nobel Prize in Economics, once said that Schumpeter was great as both a scholar and a personality, but that his comparative advantage may have been greater as a personality. I don't quite agree, but there's no denying his personal appeal, especially to women and to scholars and students of both sexes.

The duel you mention, by the way, was over students' access to books. Schumpeter had given out heavy assignments, the librarian had refused to allow the students to check out the assigned books, and when Schumpeter threw a tantrum (he was only 26, and had just started teaching), the librarian challenged him to a duel. Schumpeter won the duel by cutting a small slice out of the librarian's shoulder. The two men later became good friends, and the students got access to the books.

Like many geniuses, Schumpeter held himself to impossibly high standards, and he constantly brooded that he wasn't living up to them. There was extraordinary tension between his devotion to rationality ("I have given my life to reason," he once wrote in his diary), and the overwhelming power of his emotions. He was an intellectual prodigy, and, like many former boy wonders, was surprised to find that he could not work during his 40s and 50s at the furious pace he had set during his 20s. Even so, he did some of his very best work in middle age. Capitalism, Socialism and Democracy, for example, appeared when he was 59.

There's no denying his personal appeal, especially to women and to scholars and students of both sexes.

Then, too, he suffered some dreadful personal tragedies, such as the death of his 23-year-old wife in childbirth, and of his newborn son 4 hours later. This was the pivotal event of his life. In the months and years that followed, he drew on the great depth of his character—which went much deeper than he had realized—and redoubled his effort to work out the full complexity of capitalism as an economic, cultural, and social system.

As for my personal feelings about him, I think Schumpeter is one of those historical figures that anyone would love to have dinner with, as many people have said of Benjamin Franklin. He was just so witty, knowledgeable, and downright interesting that you couldn't come away without feeling enriched. Weaving together the fascinating story of his life with an interpretation of his great body of work made the writing of my book not only a challenge, but also a tremendous pleasure.

Prologue: Who He Was and What He Did

by Thomas McCraw

Questions about capitalism—what it is, how and why it has worked well in some places and not others—are among the most important that people and governments have faced. This has been true for about three hundred years, and seldom more so than in the present and the recent past. Recall the turbulent transition from the last decade of the twentieth century to the initial one of the twenty-first: the sudden collapse of communism, for seventy years a serious challenger to capitalism; the riotous prosperity of the 1990s, when entrepreneurs became folk heroes; the ensuing epidemic of corporate scandals, which bankrupted shareholders and employees and disgraced capitalism itself; then the scourge of international terrorism, portending warfare without end; and finally the spectacular economic gains in many parts of the world—most notably China, which combined a new capitalist economic system with an old communist political regime.

How can one understand these issues? Why, after seven decades of struggle, did capitalism triumph over communism? Are exorbitant executive pay schemes and continual accounting frauds corruptions of capitalism or its natural state? When people ask about terrorists “Why do they hate us so much?” what part does capitalism play in the definition of “us”? How long can China and other countries sustain their economic progress without granting more political liberties to their people?

Some of the clearest guides to these kinds of questions come from Schumpeter, who assessed capitalism as an expression of innovation, human drama, and sheer havoc—all going on at once. He told of capitalism in the way most people experience it: as consumer desires aroused by endless advertising; as forcible jolts up and down the social pecking order; as goals reached, shattered, altered, then reached once more as people try, try again. For capitalism, and for Schumpeter personally, nothing was ever stable. Uproar was their only music.

Like nearly everyone who has thought deeply about capitalism, Schumpeter came away with mixed feelings. He regarded himself as a conservative and planned to write a book on the meaning of conservatism. But, as he told his fellow economist John Kenneth Galbraith, “I am pretty sure that no conservative I have ever met would recognize himself in the picture I am going to draw.” Schumpeter abhorred some of the banalities of business culture and revered the artistic attainments of the Old World. He knew that creative destruction fosters economic growth but also that it undercuts cherished human values. He saw that poverty brings misery but also that prosperity cannot assure piece of mind. 6

A steep rise in living standards would seem to be a prize of supreme value for any society. Yet capitalism has a dreadful reputation for robbing the poor to profit the rich, and it has never achieved what most people regard as a fair distribution of its bounties. In some countries it still represents a curse to be resisted and overcome. Even its fortunate beneficiaries in rich countries often have a guilty feeling that capitalism is an unworthy pursuit—something to be accepted but not celebrated. As Schumpeter himself put it, “The stock exchange is a poor substitute for the Holy Grail.”7

He applied his immense energy to analyzing and explaining capitalist innovation not only for other experts but sometimes for the nonspecialist. From the compelling story of his life and work, a reader can grasp the basic mechanism of the capitalist engine about as well as from a whole shelf of textbooks. The subject is momentous, and its full social mechanism quite intricate. But its economic essence is not very complicated. As Schumpeter himself wrote in 1946, at the beginning of his long article on capitalism for the Encyclopaedia Britannica, “A society is called capitalist if it entrusts its economic process to the guidance of the private businessman. This may be said to imply, first, private ownership of nonpersonal means of production … second, production for private account, i.e., production by private initiative for private profit.” He went on to say that a third element is “so essential to the functioning of the capitalist system” that it must be added to the other two.8

This third element is the creation of credit. The core ethos of capitalism looks constantly ahead and relies on credit and 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 lying at hand. In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations.

Reprinted by permission of Harvard University Press from Prophet of Innovation: Joseph Schumpeter and Creative Destruction by Thomas K. McCraw. Copyright 2007 by the President and Fellows of Harvard College. All rights reserved.

6. Schumpeter to Galbraith, October 28, 1948, in Hedtke and Swedberg, eds; Briefe, p. 366.

7. Schumpeter, Capitalism, Socialism and Democracy, p. 137.

8. Schumpeter, “Capitalism,” Encyclopaedia Britannica (New York: Encyclopaedia Britannica, 1946), VI, p. 801.