Thursday, June 28, 2007


Creative Destruction: The Words of the Prophet
By Nick Schulz :

Editor's Note: Thomas K. McCraw is the Isidor Straus Professor of Business History, Emeritus at the Harvard Business School. His book Prophets of Regulation: Charles Francis Adams, Luis D. Brandeis, James M. Landis, Alfred E. Kahn won both the Pulitzer Prize for History and the Thomas Newcomen Award which is given for the best book on the history of business published over a three-year period.

McCraw is the author of a remarkable new book, Prophet of Innovation: Joseph Schumpeter and Creative Destruction. McCraw recently spoke with TCS editor Nick Schulz about Schumpeter's life and work.

Nick Schulz: Thomas McCraw, thanks for joining us today. In your book you write that "Schumpeter believed that the world could fully benefit from capitalism only if people understood how it works." Did he overstate the case here? For example, people benefit from all sorts of technologies without understanding how they work. Ask someone to describe how a microwave oven works, or a refrigerator, and he will have no idea. So why was understanding how capitalism works so important to Schumpeter?

Thomas K. McCraw: As soon as your microwave or refrigerator breaks down, you become a lot more interested in how it works. Can you fix it, or are you going to have to buy a new one?

Schumpeter believed people should understand how capitalism works because he thought it to be fragile. When he wrote Capitalism, Socialism and Democracy in the late 1930s and early 1940s, capitalism's reputation was at a very low ebb. The Great Depression (1929-1941) had shaken people's faith in capitalism to the core. Then, the onset of World War II seemed to throw everything up for grabs. As you know, the war was provoked by powerful fascist regimes in Germany, Japan, and Italy. Those countries lost the war, but Schumpeter believed the biggest winner to have been not the capitalist democracies but the Soviet Union. Despite horrendous casualties, the Soviets had overrun half of Europe in 1944 and 1945. So, by the time the third edition of Schumpeter's book appeared in 1950, about 40 percent of the world's people were living under Communist regimes: in Russia, Poland, East Germany, Czechoslovakia, a half-dozen other European countries, and -- most importantly -- China.

An additional 25 percent of the global population was following some other form of socialism. These countries included India and other newly-independent former colonies in Asia and Africa. Even Britain had nationalized significant part of its economy -- electric power, for example -- and under its Labour government was proceeding steadily down the road to a socialist polity.

Today, all of this is a little hard to remember. From the perspective of the early twenty-first century, when most of the world's people are living under capitalist economies for the first time in history, we easily forget how hard it is to construct and maintain a capitalist system. We really don't know what's going to happen in China, for example, with its peculiar mixing of a capitalist economy with a communist government. And can Russia's authoritarian system coexist with the entrepreneurial spirit that drives innovation and defines capitalism?

Taking the very long view, capitalism as we know it has existed for only about 350 years. That fact alone tells us that it's not the natural state of human existence. If it were, it would have appeared about 10,000 years ago, and certainly no later than the Greek city-states of antiquity. Because Schumpeter had such a deep understanding of history, he saw very clearly that capitalism could perish. In Capitalism, Socialism, and Democracy, he showed how that might happen -- not from economic causes but for political, social, and cultural ones.

Schulz: You write that "capitalism, of all economic systems, is so distinctly oriented to the future." As a champion of capitalism's economic dynamism, Schumpeter was in some ways an anti-conservative. And yet you point out that he harbored many conservative views and considered himself a conservative. You quote an historian who pointed out that in early 20th century Austria, "within a lifetime, the medieval and modern orders collided head on." Is this part of what explains Schumpeter's conservatism? What kind of conservative was he?

McCraw: Schumpeter's conservatism grew out of his understanding of the juggernaut power of capitalism. He believed capitalism to be the only route to a rise in living standards for the masses. At the same time, he saw that it undercut many cherished human traditions. These included close ties to local communities, reciprocal obligations between social groups, and the unity of families. He thought there had to be political checks on these tendencies, or capitalism might destabilize society altogether. He believed, as Edmund Burke put it in Reflections on the Revolution in France (1790) that "Good order is the foundation of all good things."

In a lecture he delivered in 1941, Schumpeter gave a very simple definition of conservatism: "the bringing about of your social structure to another social structure with a minimum of loss of human values." He regarded the literary and artistic culture of western civilization as a priceless heritage. And he believed the British system to be the optimal way to organize a government -- a constitutional monarchy with a symbolic but powerless sovereign, a bicameral House of Lords and Commons, and an elite, apolitical civil service that did not interfere with entrepreneurship and other individual freedoms. His special hero, the anti-imperialist statesman William E. Gladstone, was an advocate of free trade, low taxation, and balanced budgets, but also of measures to soften the impact of industrialization on the poor.

Schumpeter would unquestionably have objected to the American government's deficit spending, the incompetence of many of its administrators, its politicization of the civil service, and its sometimes reckless military adventures overseas, which he called "ethical imperialism."

Schulz: You reveal how Schumpeter was for a time obsessed with developing an "exact economics" grounded in mathematical determinacy and precision. He ultimately abandoned his quest, and pointed to the importance of history, sociology and psychology in a proper understanding of economics. Today there is a criticism of academic economics heard in some quarters (a criticism I share) that says economics places too much emphasis on math, formal models, etc. What would Schumpeter make of the state of the economics profession today?

McCraw: He would applaud the remarkable progress toward a more exact economics, and he would not quarrel in the slightest with the sophisticated use of math. After all, he declared many times his belief that economics is a science. But he'd object strenuously to the narrowing of the discipline -- its movement away from history and other social sciences. In Schumpeter's time, a graduate education in economics required courses in economic history and often in economic thought as well. Today that's no longer true, largely because the learning of more and more math has crowded them out.

Of course, increasing specialization, and the isolation of disciplines from one another, are perhaps inevitable trends, as knowledge explodes in both the natural and the social sciences. But there's a steep downside. Few academics have much awareness of the history of their own discipline, whether it's physics, chemistry, economics, law, or medicine. Schumpeter wrote his huge work History of Economic Analysis partly to correct what he saw -- even in the 1940s -- as this growing ignorance. As he put it, "Modern problems, methods, and results cannot be fully understood without some knowledge of how economists have come to reason as they do." That is, the scientific method requires a constant back-and-forth movement between empiricism and theory. Today, in many disciplines, the theorems come first, and researchers seek out data that will confirm them, suppressing -- whether deliberately or sub-consciously -- data that point in the opposite direction. The use of supposedly scientific economics in partisan politics, while inevitable, only magnifies this trend.

Schulz: Entrepreneurship is notoriously difficult to "model" in any meaningful sense. But is progress being made in this area? Or will it always be outside the reach of the precision tools available to economists?

McCraw: A lot of progress has been made, especially if one substitutes "innovation" for "entrepreneurship." The two words aren't synonymous, of course, because of the powerful human element inherent in entrepreneurship. But the work of such scholars as Nathan Rosenberg, Richard Nelson, Sidney Winter, F.M. Scherer, and about fifty other economists -- all of them Schumpeterians -- is very encouraging.

To put this same point another way, Schumpeter's seminal idea of "creative destruction" has been mathematized by economists such as Peter Howitt, Philippe Aghion, and a few others. But I don't think entrepreneurship can ever be modeled in the precise mathematical way of, say, partial equilibrium and other economic questions. I hope I'm wrong in this, but I don't think I am.

Schulz: You write that Schumpeter's years in business gave him a "direct education into the nature of capitalism." What specifically did he learn? Is it the kind of knowledge that can only come from hands-on business experience?

McCraw: Schumpeter practiced law for a year, served as Austria's finance minister for seven months, and worked as in investment banker and investor for almost four years. This, of course, adds up to real-world practice that most academics never have. The experiences didn't change Schumpeter's core vision of capitalism so much as they confirmed it. In particular, his years as a banker taught him about the difficulty of starting new ventures, the constant pressures of competition, and -- most of all -- the big payoffs for success and penalties for failure.

As an investor, he made a fortune and then promptly lost it in Vienna's stock market crash of 1924. It took him 11 years to pay off his debts from that one event. Later, he wrote that in capitalist economies, rewards and punishments for good and bad judgment come quickly and cruelly: "Prizes and penalties are measured in pecuniary terms. Going up and going down means making and losing money . . . The promises of wealth and the threats of destitution that [this system] holds out, it redeems with ruthless promptitude."

Any economist knows these things intellectually. But to experience them personally is like the difference between reading about Mount Everest and trying to climb it.

Schulz: One of Schumpeter's least appreciated insights, in my view, is his claim that innovation is mostly "a feat not of intellect, but of will ... a special case of the social phenomenon of leadership." How did he come to see innovation this way? Is this something that was appreciated in his time or, in your view, appreciated today?

McCraw: I believe that people who've worked in business or served in the military know this a lot better than most academics do.

You asked earlier about the difficulty of modeling entrepreneurship. Schumpeter's insistence on the importance of will and leadership underscores this difficulty. How can you assign a numerical value to either of these phenomena, or put them into a rigorous equation? If you're studying innovation, you can count the number of patents filed over a specified period, and also the citations of those patents, and then do regression analyses and write some equations. This is a fruitful line of work, but it's also pretty limited in telling the larger story of innovation. For that, you have to have a narrative -- a story of Thomas Edison, Henry Ford, Bill Gates, Sam Walton, Jeff Bezos, or Akio Morita of Sony. All of these are stories of innovation driven by will and leadership as much as by intellect. Similarly with military leaders: Caesar, Napoleon, Grant, Lee, de Gaulle, Patton -- innovators all, but driven more by will than by intellect.

Schulz: In an essay in 1930 Schumpeter felt compelled to argue against an idea then fashionable that "limits to technological progress were rapidly approaching." This seems to be a persistent theme in business and economic commentary. What accounts for its longevity?

McCraw: I have no idea. The thought goes against almost everything that's happened over the last 350 years. It's true, of course, that economic progress is going to run up against environmental limits of the most serious kind. But even here, if market incentives are properly structured, the problems can be very much mitigated. The question is whether politicians and voters have the will to do such obvious things as impose heavy taxes on pollution of all kinds, including hydrocarbon emissions -- including very high taxes at the gasoline pump, similar to the high taxes we now impose on cigarettes. If that were to happen, we'd see an outburst of fuel-saving technology -- innovations we've only dreamed of.

In the larger sense, a drive for progress seems to be hard-wired into human nature. The philosopher George Santayana once remarked that the main thing that separates human beings from other animals is aspiration. Whereas lions and tigers may look for richer hunting grounds, human beings (once adequately fed and sheltered), will press on indefinitely, seeking ever greater challenges. As a species, we seem to need these constant challenges. We're never satisfied.

Schulz: Schumpeter long felt that America was unsophisticated, but his views on this changed after World War II. What accounted for his earlier view, and what accounted for the change?

McCraw: By Schumpeter's standards, the United States was a very young country. His own family had lived in the same small European town for 400 years, and when he was born in 1883 the American Declaration of Independence was only 107 years old. So the country was too young to have the sophistication and culture of the Old World.

By the end of World War II, however, the Americans had proved their power on the world stage, and had led in the creation of such institutions as NATO, the World Bank, the International Monetary Fund, the United Nations, the Marshall Plan, and the General Agreement on Tariffs and Trade (now the World Trade Organization). And the Occupation years in Germany and Japan were phenomenally successful.

Schulz: It is striking how popular Schumpeter was in Japan, even early in his career. What accounts for his popularity there?

McCraw: Schumpeter was welcomed as a hero and a prophet when he visited Japan in 1931. This derived from two sources: first, his great book, The Theory of Economic Development, and second his having trained some leading Japanese economists. Many aspects of the extremely rapid industrialization of the country fit the Schumpeter's formula for growth -- especially his emphasis on innovation and on what he called "credit creation."

In the West, to this day, we tend to underestimate the innovative genius of both the early Japanese development -- from the 1880s through the 1930s -- and especially of the country's "economic miracle" of 1953-1971.

Schulz: Schumpeter had an absolutely astonishing level of output for a scholar. Can you give readers a sense of how much work her produced?

McCraw: This is an easy question to answer, since I've read all of it so recently.

He published about five million words -- two million in English and three million in German, much of which has now been translated into English and many other languages. I'm including in this total his books, articles, book reviews, and published lectures. I don't include his thousands of letters and copious diary entries.

To put the five million words into perspective: a book of 300 pages contains about 100,000 words. So by this measure Schumpeter wrote the equivalent of about 50 books. And he did it without co-authors and with minimal research assistance. He was an obsessive and indefatigable scholar: a very unusual combination of a grind who was also a great showman, a ladies' man, and an altogether electrifying personality.

Schulz: Your book came out right at the time that Alfred Chandler died. Please discuss the importance of Chandler's work and Schumpeter's influence on Chandler.

McCraw: Chandler was the greatest scholar I've ever known personally, and I've written about him at some length in the introduction to a book of his essays I edited, called The Essential Alfred Chandler. His signal achievement was to bring genuine rigor to the study of business history -- to establish it as a new sub-discipline, one that's now thriving all over the world. I was extremely fortunate in having been so close to Chandler, as a protégé, then a colleague and friend, and finally as his successor as Isidor Straus Professor of Business History at Harvard. I don't think anyone outside my own family was happier than he was when I won the Pulitzer Prize in history, as he had done himself seven years earlier.

Al's death, which was unexpected even though he was 88 years old, hit me very hard. Not long before he died, I had spent an hour with him and given him a copy of my book, in which he appears as one of the many scholars influenced by Schumpeter. He met Schumpeter only a few times, but the influence ran very deep. Chandler's chief inspiration in graduate school had been the eminent sociologist Talcott Parsons. Parsons had previously worked with Schumpeter off and on for 20 years, first within Harvard's Economics Department, and later when the sociologists split off from economics to form their own Social Relations group. Parsons often said that it was Schumpeter who taught him to think systemically. And Parsons's "structural-functionalism" is one of the principles that lie nearest the heart of Chandler's organizational approach to his magnificent studies of business.

Schulz: What do academics and lay people not appreciate about entrepreneurship today that would frustrate Schumpeter were he still with us? Or would he believe we have a sufficient appreciation for the role and power of the entrepreneur?

McCraw: I don't think they have much understanding of how much hard work it takes to be a successful entrepreneur. The competitive pressures are relentless and round-the-clock. Meeting them requires something close to obsession. In a startup, you have to worry about every single aspect of your business: finding the right product and business model, hiring and firing the right people, and -- above all -- finance. The saying about never having met a payroll is a cliché derided by many intellectuals, but the fact is that entrepreneurs have to worry constantly about where their next dollar is coming from. That part of the task is not quite as difficult now as it was in Schumpeter's time, because there's so much more access to venture capital, "angels," and so on. But it is still very, very hard, and the term "sweat equity" remains one of the keys. Everyone is familiar with the names of 20 or 30 successful entrepreneurs. Nobody has heard of the thousands of unsuccessful ones.

Schulz: Schumpeter famously said "When I see those who espouse my cause, I begin to wonder about the validity of my position." Where would Schumpeter fall on the political spectrum today?

McCraw: Here I think Schumpeter was referring to the intellectual flabbiness of some moss-backed, knee-jerk conservatives whom he knew. The times he lived through -- especially the period from the beginning of the First World War in 1914, through the Great Depression of the 1930s, and then until the end of the Second World War in 1945 -- demanded new kinds of thinking. If the ideas were good ones, Schumpeter didn't care where they came from. The problem was that not many of them were coming from conservatives. As he remarked in 1937, "It is one of the humors of the situation that [conservatism] has never successfully defined itself." That's less true today, of course, in a period when the intellectual rigor of conservative thinking has been pretty strong for about 30 years. On the other hand, the political history of the last six years shows how easily conservatism, like liberalism, can simply go off the track and violate some of its own bedrock principles.

As for the question of exactly where Schumpeter would be on today's political spectrum, it's impossible to say -- just as it would be for many other deep thinkers, from Aristotle to Augustine to Aquinas. Schumpeter avoided formal political affiliations, and was always at his best as a critic. As one of his best friends once said, "By conviction as well as by temperament, he was a thinker, not a doer . . . but what an unusual ivory tower it was!"

Schulz: Thank you for taking time to talk to us.

McCraw: Thank you

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