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"Understanding the Economic Basics & Modern Capitalism: Market Mechanisms and Administered Alternatives"
by Dan Blatt - Publisher of FUTURECASTS online magazine.

Smith: Wealth of Nations.   Ricardo: Principles.
Marx: Capital (Das Capital).   Keynes: General Theory.
Schumpeter: Capitalism, Socialism and Democracy.

Economics is the miracle science. Even imperfect capitalist markets routinely raise billions out of poverty.

Table of Contents & Chapter Introductions

FUTURECASTS JOURNAL

Schumpeter on Creative Destruction

(with a review of "Can Capitalism Survive: Creative Destruction and the Future of the Global Economy," a  segment of "Capitalism, Socialism, and Democracy by Joseph A. Schumpeter.)

May, 2012
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Creative Destruction:

 

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  Industrial policy, socialist and entitlement welfare state programs and the spreading of moral hazard credit guarantees broadly over the commanding heights of the private economy have been widespread as responses to recent economic difficulties.
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It is the pain and anguish of European austerity efforts that is emphasized rather than the government profligacy that ultimately makes austerity absolutely essential.

  That government policies and agencies played a primary role in the boom and bust of the Credit Crunch recession, and that government profligacy plays the predominant role in Europe's sovereign debt crises, is quietly disappearing from media coverage and commentary. Blame and regulatory attention is concentrated on the very real excesses of the private financial sector, while Fannie Mae and Freddie Mac, the affordable housing laws and tax and credit policies that distort the housing and mortgage markets remain in existence. (See, Understanding the Credit Crunch.) It is the pain and anguish of European austerity efforts that is emphasized rather than the government profligacy that ultimately makes austerity absolutely essential.
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Even competitive forces that are far from perfect generate massive benefits. These benefits apply even where monopoly and oligopoly dominance is achieved.

 

Capitalism is a process of economic change.

  Indeed, Joseph A. Schumpeter, in "Can Capitalism Survive: Creative Destruction and the Future of the Global Economy," could have been writing about today instead of the economy of Great Depression. Yet once again, all blame for a major economic crisis caused predominantly by government policies is being focused on private sector miscreants, of whom there are inevitably many.
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  The benefits of private markets
are emphasized by Schumpeter. Even competitive forces that are far from perfect generate massive benefits in the private economy. These benefits apply even where monopoly and oligopoly dominance is achieved.
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  Static analysis is inherently inapt. Price competition alone is an inadequate factor in judging the benefits of private markets. Even in markets that may be far from perfectly competitive, quality competition and sales effort must be included in the analysis. Always in existence is competition that is not yet in existence - the competition from potential new entrants.
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Always in existence is competition that is not yet in existence - the competition from potential new entrants.

  Capitalism is a process of economic change, Schumpeter emphasizes. Economic analysis based on aggregate indices like Gross Domestic Product is criticized by Schumpeter. These aggregates have many flaws and have the effect of obscuring the information within them, much of which is essential for valid analysis.

  "[Not] only the material and the technique of constructing such an index, but the very concept of a total output of different commodities produced in  ever-changing proportions, is a highly doubtful matter."

  Government sector expansion is not an adequate substitute for private sector contraction, something omitted from the gross domestic product calculations of Keynesian and other left wing analysts. Infrastructure expenditures have far different economic impacts than military or welfare expenditures. Measures of inputs are poor substitutes for measures of outputs.

  New commodities as well as quality improvements escape these indices, as does "voluntary leisure." The auto of 1940 was far different from the auto of 1900, the author points out.

  "[The] capitalist process, not by coincidence but by virtue of its [mass production] mechanism, progressively raises the standard of life of the masses."
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  "It is not true after all, that there is little parallelism between producing for profit and producing for the consumer and that private enterprise is little more than a device to curtail production in order to extort profits which then are correctly described as tolls and ransoms."

  Assertions that the middle class has made no progress in the last 30 years are clearly stupid. The creature comforts possessed by middle class households now include a variety of items not previously available and those possessions previously available have vastly increased in quality and variety. Not only do middle class households now possess personal computers and other consumer electronics that did not exist in 1980, but they now often possess several of them. Even when average income within the class does not improve, most individuals advance within the class over time.
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  Capitalist economics is not a zero sum game. Th e poor are not poor because the rich are rich. Th e rapid pace at which the wealth of the rich is increasing has not prevented the other economic classes from making impressive advances in recent decades.
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  In any event, in addition to natural economic developments like globalization and technological advance, much of the increasing gap between the rich and the middle class is the result of long periods of artificially low interest rates and the increasing financialization of the economy that is the result of Federal Reserve Bank policy that takes income from the public and directs it to Wall Street.

The ongoing turnover of Creative Destruction does not show up in the simplistic analyses based on economic aggregates.

  The importance of the right to fail for properly functioning capitalist markets is highlighted by Schumpeter. Many economists ignore the reality of Creative Destruction. The ongoing turnover of Creative Destruction does not show up in the simplistic analyses based on economic aggregates. However, the wave of Creative Destruction that continuously washed over all segments of the capitalist economy was always clearly observable for those with eyes to see. (Left wing economists from Marx to Keynes to Galbraith determinedly remained blind to this reality.)
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  The widespread incidence of imperfections in competition - monopoly, oligopoly, product differentiation, monopolistic competition - are viewed by critics of capitalism as undermining the equilibrium theory and the capitalist welfare maximization theory that are used as justifications for the profit system.

  "[The] problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them. As long as this is not recognized, the investigator does a meaningless job."

The impacts of price rigidity policies pose varied but essentially limited obstruction to competitive pressures. Indeed, Schumpeter notes that: A long run downward flexibility is then revealed that is truly impressive.

 

"The process of Creative Destruction is the essential fact about capitalism."

 

In a private economy, monopolistic practices that depart substantially from market-driven practices can in only the rarest cases persist for any extended length of time "unless buttressed by public authority."

  It is "competition from the new source of supply, the new type of organization," that is actually the most important type of competition. Such competition "commands a decisive cost or quality advantage" that will threaten the existence of even the most dominant existing factors. Even monopolies and oligopolies must fear this competition and react to it as if facing immediate price and quality competition. (Only the paranoid survive!) Schumpeter notes the progression of changes in retailing (that has in modern times led to Walmart and online sales).
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  Imperfection in competitive markets
create both advantages and disadvantages that are analyzed at some length by Schumpeter. However, all are exposed to the competitive gale of creative destruction and must respond or die. The impacts of price rigidity policies pose varied but essentially limited obstruction to competitive pressures. Indeed, Schumpeter notes that: A long run downward flexibility is then revealed that is truly impressive. Even in relation to price fixing and constraining practices, price rigidity is a much exaggerated explanation for market failures.

  "The process of Creative Destruction is the essential fact about capitalism."

  That competition and production are far from perfect does not undermine this essential process. Creative Destruction incessantly destroys existing providers and creates new ones.

  "The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumer goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates."

  In a private economy, monopolistic practices that depart substantially from market-driven practices can in only the rarest cases persist for any extended length of time "unless buttressed by public authority." "Outside the field of public utilities," domination can be attained only by competitive behavior and if domination is taken advantage of after it is obtained, it will be undermined by new competitors.

  Government support for monopoly positions can be provided by patent policy, subsidies, regulatory advantages, licensing requirements and so forth. The authorities will always provide justifications for such actions, but in only a few cases are they really in the public interest and even then usually only if limited in scope and/or duration. Patent protection is undoubtedly justified but the Mickey Mouse extensions of copyright protection have gone way overboard and are now clearly counterproductive. Many state and local governments have extended licensing requirements far more broadly than economically justified. The economic prospects of competitive capitalist markets are clearly threatened predominantly by the governments that in substantial part created and facilitate them.

Government mismanagement and waste will always limit the effectiveness of its programs.

   Indeed, it is capitalism that provides the resources that governments draw on for social welfare purposes - including funds for the unemployed, education, hygiene and care for the aged, etc. However, government mismanagement and waste will always limit the effectiveness of its programs. (It is indeed government mismanagement and waste and vulnerability to fraud that increasingly leaves its education and health care programs in a state of financial crisis.)
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Profits must not exceed the point where they induce new entrants. Monopolistic advantage can be maintained "only by alertness and energy."

  There are natural advantages to size that support dominant positions. Schumpeter points out that many of the most revolutionary economic advances have come from monopolies and oligopolies. Competitive industries with myriad small competitors may be unable to develop superior methods and may also be more vulnerable to economic recessions. He points out that American agriculture and English textiles and coal mines were especially hard hit by the Great Depression.
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  Most businesses that achieve and for some time maintain dominance in an industry do so by taking advantage of economies of scale and better credit ratings. They thus may provide higher quality goods at lower costs than smaller competitors. However, to maintain their dominant position, they cannot retain all of these benefits for themselves. They must pass on most of such benefits to their customers to deter the entrance of new competitors. Profits must not exceed the point where they induce new entrants. Monopolistic advantage can be maintained "only by alertness and energy."
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  Big business capitalism has played major roles in observable productivity advances and living standard gains. Schumpeter notes that the Aluminum Company of America in just 40 years reduced the price of aluminum by over 90% and increased the market for aluminum products more than 3 1/3 times. Schumpeter question whether a bunch of small competitive producers could have so successfully increased productivity and developed new uses for the metal. The Aluminum Company of America was driven by the need to stay ahead of the wave of Creative Destruction that was flowing through even the aluminum production industry.

  The AT&T monopoly clearly provided by some considerable margin the best large-scale telephone system in the world. Among the advantages of the AT&T telephone monopoly were the technological advances that flowed from the legendary Bell Laboratories. However, AT&T failed miserably to understand the full competitive opportunities of its own technological advances. The removal of government protection exposed AT&T to some competition and thus dramatically demonstrated the costs and inherent weaknesses of monopoly production. The original AT&T has since been absorbed by one of its more agile rivals.

The inevitability of socialism:

 

 

 

 

 

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  Declinist views have been a common feature of left wing economic theory from Marx to Keynes to Galbraith. The similarities between Marx and Keynes in what Schumpeter calls "the theory of the vanishing investment opportunities," is emphasized by Schumpeter. Both Marx and Keynes "stress the effects of capital accumulation and capital agglomorization on the rate of profits and, through the rate of profits, on the opportunity to invest." If investment opportunities are in inevitable decline, capitalism cannot sustain itself. (The decline in the profit rates of capital have been a feature of the growth of capitalist systems from even before Adam Smith's times.)
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Schumpeter accepts the widespread expectation that capitalism will metamorphose into a socialist system.

  Schumpeter thoroughly debunks the declinist - generally left wing - theories of the Great Depression period. He expresses harsh criticism of some key Keynesian beliefs. In particular, it was the Depression that caused "hoarding," Schumpeter correctly points out. Savings did not cause the Great Depression.
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  He nevertheless accepts the widespread expectation that capitalism will metamorphose into a socialist system. Schumpeter expects that even technological advancement will become so automatic that entrepreneurial talent will no longer be required. Capitalism will thus reduce its own profitability and the need for capitalism itself.

  "The perfectly bureaucratized giant industrial unit not only ousts the small and medium-sized firm and 'expropriates' its owners, but in the end it also ousts the entrepreneur and expropriates the bourgeoisie as a class which in the process stands to lose not only its income but also what is infinitely more important, its function."

    Schumpeter here is almost Marxist in the ridiculousness of these assumptions. Results similar to that experienced by AT&T have been the rule in a variety of industries where the removal of government regulatory constraints exposed dominant businesses to competition.
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   Academic economists frequently have no idea of what management is all about. Marx thought that management involved little more than the hiring of professional managers and the issuing of "socialist directives."  See the Introduction to Karl Marx, Capital (Das Kapital) (vol. 2 (I)). Socialist directives frequently involved those "Five Year Plans" that were once such a familiar part of the 20th century socialist economic scene and that were actually taken seriously in various intellectual circles.
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  There is often intentional blindness about the inherent ineptness of government management and the frequency with which governments exhibit a negative learning curve in their economic management efforts. See Part II of Government Futurecast. There is also frequently intentional blindness about the roles of competition in punishing managerial complacency in large, dominant corporations.

Thus, big business is inherently vulnerable to demagogic attack. Short term impulses will triumph over the long term policies needed for prosperity, and political realities will undermine the capitalist system.

    Schumpeter expects all dominant businesses to be like General Electric has become. Like Marx, he views the modern large corporation as a development that separates ownership and managerial interests and renders shareholders functionless, thus facilitating the demise of capitalism and its transition to socialism. He expects them to develop the ability to preside over the Creative Destruction process to the exclusion of the independent entrepreneur. This capacity will undermine the importance of small businesses in the Creative Destruction process. (But frequently, big businesses buy their technological advances from small businesses.)
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  Like Marx, Keynes and Galbraith, he views the shareholder as useless. Workers and even management and small shareholders have no intense loyalty to any big business or to its form of ownership. They will not fight the political battles to protect the property and contract interests of big business.
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   Schumpeter, like Adam Smith, recognizes the inherent conflict of interest between the agent interest and ownership interest in the corporate organization.  (See, Adam Smith, " The Wealth of Nations (II)," at section on "Regulatory companies.") The managerial class works increasingly for itself and immediate personal benefits rather than for the future of the corporation.

  Indeed, it is precisely the strength of their short term interests that recently led so many corporate officers and employees to  heedlessly undermine the interests of their organizations and the entire economy. See, Moral Hazard & Conflicts of Interest in the Credit Crunch,. Smith would undoubtedly be amazed at how well the corporate structure works in our modern economy and how relatively rarely the economy is hit with major corporate scandals. He thought that partnership forms of organization would ultimately predominate.
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  The ability of shareholders to collectively vote with their feet - to sell their shares - and impose low p/e ratios on poorly managed corporations is a far more effective and infinitely more efficient disciplinary mechanism that any administered regulatory alternative.

  Schumpeter is already, in the 1930s, pessimistic about the survival of bourgeois family and lifestyle values. He fears that corporate officials may ultimately not even consider children and private homes as worth the burden, or as a reason to be concerned about the future of the economic system.
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  Thus, big business is inherently vulnerable to demagogic attack. Short term impulses will triumph over the long term policies needed for prosperity, and political realities will undermine the capitalist system.
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The more that capitalism achieves, the more attractive it is as a target for envy and redistributionist fervor. There will always be intellectuals who will play to and rationalize and provide direction for these attacks.

 

"Strictly speaking we do not even know whether socialism well actually come to stay. For to repeat: perceiving a tendency and visualizing the goal of it is one thing and predicting that this goal will actually be reached and that the resulting state of things will be workable, let alone permanent, is quite another thing."

  Inevitably, there will be intellectuals who will turn on the capitalist class and system and provide direction for the mass impulses of envy and personal greed that seek redistribution of capitalist wealth. The intellectual is basically an onlooker and outsider, whose "main chance of asserting himself lies in his actual or potential nuisance value."

  "Intellectuals are in fact people who wield the power of the spoken word, and one of the touches that distinguish them from other people who do the same is the absence of direct responsibility for practical affairs. This touch in general accounts for another -- the absence of first-hand knowledge of [practical affairs] which only actual experience can give." (Schumpeter here could be describing himself.)

  The more that capitalism achieves, the more attractive it is as a target for envy and redistributionist fervor. There will always be intellectuals who will play to and rationalize and provide direction for these attacks. (This is just recognition that demagogy remains the primary threat to modern capitalist democracies as it was to pre-capitalist democracies.)

  "[Thus,] public policy grows more and more hostile to capitalist interests, eventually so much so as to refuse on principle to take account of requirements for the capitalist engine and to become serious impediments to its functions."

  Thus, policy is today guided by nebulous concepts of "fairness" regardless of economic impact.

  "[We] know nothing as yet about the precise way by which socialism may be expected to come except that there must be a great many possibilities ranging from a gradual bureaucratization to the most picturesque revolution. Strictly speaking we do not even know whether socialism well actually come to stay. For to repeat: perceiving a tendency and visualizing the goal of it is one thing and predicting that this goal will actually be reached and that the resulting state of things will be workable, let alone permanent, is quite another thing."

  The demoralization of capitalist and bourgeois interests by the Great Depression is clearly reflected in Schumpeter's views. During that time, there was little effort at defense against left wing attacks of all kinds. However, unlike Marx or Keynes or later, Galbraith, Schumpeter never assumed that socialist polices, once adopted, would be successful - or even viable.
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  Schumpeter's view was proven by results. See Schumpeter on Socialism   for a review of the socialism related parts of Schumpeter, "Capitalism, Socialism, and Democracy." Abroad, socialist causes did indeed triumph widely until they demonstrated the vast incompetence of government management efforts and the impossibility of socialist success. See, Muravchik, "Heaven on Earth." Only the James Madison design that wisely imposes Constitutional limits on the economic powers of the Federal government saved the U.S. from the socialist tide that was sweeping over Europe in the post WW-II period. The U.S. was spared the economic horrors that ultimately always accompanies socialism.
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  Today, it is again Madison who stands in the way of a left wing disaster - the entitlement welfare state. Madison is accordingly under attack as archaic and out of touch with modern "needs." Under the rubric of  the "living" Constitution, intellectuals urge that constitutional constraints be interpreted away to empower the federal government to meet modern "needs." Beware of those who attach adjectives to cherished nouns!
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  Again, the left wing triumphs and the entitlement welfare state spreads its smothering fog over many of the economies of the advanced economic states. Again, however, these triumphs will be temporary. As long as political democracy itself functions, electorates will not tolerate the malfunctioning economic systems inevitably produced by major left wing policies.

  Electorates will always turn on those responsible for the policies that undermine the economy -- once they correctly identify the responsible political groups. However, the policies that initially undermine economic performance are often those of self-interested big government conservatives, such as those of the 1920s and the Bush (II) administration. It is not always clear - as it was during the Carter administration at the end of the 1970s - how much responsibility lies with left wing demagogues and how much with the unprincipled political hacks of right wing big government political alternatives. The electorate can only churn incumbents until, as in the 1980s, they empower a political class that can get it right.

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