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The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (Social Science Classics Series)

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The Theory of Economic Development represents a high point in the history of economic science. Schumpeter had a clear understanding of the difference between static and dynamic issues in economics, and an appropriate appreciation of the latter. This book also shows how advanced Schumpeter's thinking was. On page 10 Schumpeter appears to anticipate the modern definition of economics- 20 years before Robbins wrote his Nature and Significance of Economic Science (was this in the original edition, or just in my 1934 reprint?). Chapter one sorts out Say's Law of Markets in detail, and explains its static nature. Chapter two explains economic development in correct dynamic terms (unlike the pseudo-dynamics of Neoclassical growth theory). Schumpeter is able to explain dynamics because he examines entrepreneurship (and vice versa). Schumpeter also leaves room for real institutions, especially financial markets.

I can honestly say that I learned some new and important things from reading this book, despite the facts that I have a PhD in economics and took my first economics class 21 years ago. Unfortunately, most economists would learn more from reading this book than I. This is a sad commentary on the current state of affairs in economics. Schumpeter was interested in matters of great consequence and thought about them deeply. There is simply no comparison between Schumpeter's insightful analysis and the tedious and purely imaginary intellectual constructs of Solow influenced math modelers. There is a clear difference between Schumpeter's analysis and the intellectual gymnastics of modern mathurbationists. Schumpeter was a true professional.

I was somewhat surprised by the extent to which Schumpeter's ideas fit with the ideas of Mises, Kirzner, and Lachmann. Schumpeter is often seen as an Austrian born Walrasian instead of as an Austrian economist in the Menger-Mises-Hayek tradition. There are clear Austrian influences on Schumpeter's thinking, though he was not a Mises clone. I was already impressed with Capitalism, Socialism, and Democracy. Schumpeter was a true genius, and an economist on par with Ricardo and Hayek. Read this book to learn some development economics, and a little intellectual history too.

This book provides a useful corrective to some of the shortcomings of the so-called Austrian theory of Capital and the Business Cycle. Schumpeter, who studied under the great Austrian economists Bohm-Bawerk, was too much of an independent thinker to be part of an economic movement or school. The Theory of Economic Development is his declaration of independence from Austrian capital theory. In the book, he introduces a theory of development and the business cycle that shocked his more orthodox colleagues. Economic development, Schumpeter argues, involves transferring capital from old businesses using established methods of production to businesses using new, innovative methods. Schumpeter's special insight comes in trying to explain how the transfer of capital from the old to the new takes place. Schumpeter argued that it takes place through credit expansion. Through the fractional reserve system, banks are able to create credit, quite literally out of thin air. This money is lent to businesses specializing in new methods of production, who then bid up the price of production goods and consumer goods in their effort to pay for the production goods they require. Thus a form of inflationary spoliation takes place at the expense of established businesses and consumers. Although Schumpeter does not draw the spoliation inference from his theory, it is nonetheless there in the text for all who can see. Credit expansion is a form of spoliation, a form of robbery hardly distinguishable from counterfeiting. But what is unique about the capitalist engine of production is how it uses spoliation in the service of progress. And not merely spoliation through credit expansion, but spoliation through protectionism, stock manipulation, corporate welfare, cartels and monopolies, and outright fraud and manipulation. Schumpeter's book sheds light on just one aspect of this spoliation, and from this stems the book's vital importance to economic theory.

In this important book Schumpeter explains the ECONOMIC origins of business cycles. In a convincing way Schumpeter argues that business cycles are inevitable in a developing economy.

This does not mean that there are no other causes of business fluctuations such as changes in commercial policy, wars, inflationary government finance or panics. But these constitute non-economic data and cannot be explained by economic theory.

Conventional macroeconomic theory tends to explain business cycles by some kind of error and focus on correcting this error either by active policy or by advocating a hands-off policy. In this view business cycles have no function.

In a stationary ,non-developing economy (i.e. absence of innovations) there would be very little uncertainty. If you and your competitors have been selling essentially the same product in the same market year in year out and if this were to apply to all products and services would there be any economic risk (fires, epidemics and tax increases are non-economic data) left ? Were there any true economic causes, i.e. causes that economics can explain, of business cycles in the Dark Ages ?

There is still something to be said for Keynesian theory (although not for policy) in that uncertainty does influence investment decisions and that because of uncertainty in a monetary economy some hoarding of purchasing power does occur. But these are mere symptoms of underlying endogenous business cycles caused by the inflationary investment booms - "animal spirits" if you like - invoked by the swarms of innovating firms, e.g. the internet bubble, and the deflationary busts that follow when the old firms die off and yesterday's innovators become part of the stationary cycle. Schumpeter explains the origins of economic uncertainty.

What Schumpeter teaches us is that booms and recessions are necessary phenomena in developing economies, that can't be removed or corrected if we are not to thwart the creation of new wealth by innovation. Recessions are the price we pay for long term economic growth. However, recessions can lead to unnecessary panics that cause unnecessary harm to the economy. Here governments or central banks are able to, and should in my view, correct.

I hope you enjoyed this review and welcome any comments.

Schumpeter had an expression that intuitively sums up in a few choice words quite a few of the theoretical concepts of J M Keynes and the empirical/statistical breakthroughs of Benoit Mandelbrot.Unfortunately,Schumpeter lacked the technical training in mathematics,statistics and probability that he needed in order to give a rigorous exposition of his intellectual and intuitive discoveries.Those few choice words are"regular irregularity".Looking at the data available to him early in the 20th century,Schumpeter was able to categorically argue ,correctly ,that price movements over time in different markets and changes in investment over the business cycle could NOT be modeled by assuming that a normal probability distribution could be applied.Schumpeter was the first economist to make a clearcut distinction between risk(applying a normal probability distribution with a stable mean and variance(standard deviation))and uncertainty.Uncertainty would automatically arise over time due to the regular irregularity of constant(nonconstant)technological innovation,change and advance over time.It is quite easy to see that Mandelbrot's nonparametric two variable constructs, measuring discontinuity and short run/long run persistence/dependence(as opposed to the normal distributions assumptions of continuity and independence),are described by Schumpeter's"regular irregularity".Unfortunately,instead of breaking with the classical and neoclassical schools of economics,as both Keynes and Mandelbrot did,Schumpeter decided to remain a loyal soldier,downplaying his severe disagreements.This was Schumpeter's great error.He recognized the severe limitations of the standard price adjustment equilibrium demand and supply analysis,but went along anyway.The potential reader will find chapter 6 of Schumpeter's book alone to be worth the price of admission needed to obtain access to Schumpeter's brilliant breakthroughs.

Pick up any introductory economics text, and in its opening pages you'll find the uncredited work of Joseph A. Schumpeter (1883-1950). He is best known for his theory of "Creative Destruction" - which posits the economic obliteration of the old to make way for the entrepreneurial new - but here he only alludes to it. This pioneering analysis made him an early champion of entrepreneurial profit and laid the groundwork for his later masterpieces on business cycles. Schumpeter wrote extensively on capital and capitalism, earning the sobriquet the "bourgeois Marx." But he was not an iconic, dusty economist. He studied law, handled the financial affairs of an Egyptian princess in Cairo, became, at 28, the youngest full professor at the University of Graz and served as Austria's finance minister. Famous for his eccentricities, he told his students that he had three goals: to become the greatest horseman, the greatest lover and the greatest economist. He would then note that he'd fulfilled only two of his objectives. getAbstract considers this classic treatise - despite its density and a few anachronisms - required reading for students of economics and finance in academia, business and public policy.

The entrepreneurial theory of capitalism remains uniquely powerful as we near the century mark of its original publication (1912). "The Theory of Economic Development" put the concepts of creative destruction and the carrying out of new combinations before the economics profession for the first time and the profession has been collecting compound interest ever since.
Prof. Joseph Schumpeter (1883-1950) described how entrepreneurs break the cycle of routine ("the circular flow") with their chief weapon being bank credit. I don't know if Schumpeter borrowed money to get his book published but his exposition broke the circular flow of ideas among economists.
Our author leverages the general equilibrium paradigm of Leon Walras (whom Schumpeter regarded as the greatest in terms of pure theory) to magnificent effect. Among the great insights is the fact that entrepreneurs are rare even among practicing businessmen. An entrepreneur usually doesn't stay one - most settle down to running their enterprises. Schumpeter gives us a key vantage point for today's issues when he reminds us the banker, not the entrepreneur, is the risk-taker. From here it's not hard to understand why governments wish to keep banks solvent even at the cost of billions in taxpayer bailouts.
Another gem: Entrepreneurs are "irrational" in hedonistic terms in that their motives are not about satisfying wants as commonly understood (p. 92, 1934 Harvard University Press edition). Intuition has a crucial role, Schumpeter points out, foreshadowing J.M. Keynes' teachings on intuition and probability.
Capital boils down to increased purchasing power although Schumpeter makes an important distinction when he agrees with J.L. Laughlin that credit doesn't increase capital (in terms of means of production) but mobilizes it and makes it more efficient thereby leading to an increase in production (p.98).
It's back to the future again with the teaching that credit extends beyond gold and commodities with Schumpeter drawing a fine line between "normal" (for products/services already in existence) and "abnormal" credit (for future goods). Those of us friendly to the Austrian School might expect this portion to be in the chapter on business cycles. Tellingly, it's not.
The placement shows us that Schumpeter is at odds with monetary explanations of the business cycle including that advanced by his University of Vienna graduate school colleague Ludwig von Mises, who wrote the other great book of 1912 - "The Theory of Money and Credit." Schumpeter doesn't deny money's impact but his entrepreneurial theory holds that boom and bust are part of development capitalism's very nature. We come to appreciate bust upon reading Schumpeter's chiddush (novel idea) that depression spreads the boom's effects over the entire economy through the drive for equilibrium while grinding down just some areas.
Schumpeter's cycles discussion includes a cameo by the great Wesley Mitchell and recognition that businessmen can make hurtful errors during depressions but, contra Keynes, doesn't hold that government can make better ones. While not explicit, Schumpeter's theory shows how governmentalism (today's reigning paradigm) slows recovery.
Our bold teacher kicks sand in the face of conventional wisdom again when he discusses the benefits of the trusts, or what he called "the great combines." The trusts provided shots of investment during slumps without resort to central bank pin-the-tail-on-the-donkey schemes or a permanent government investment bank as advocated by Keynes. It's doubly interesting that the democratic ethos married to envy (its first cousin) undid the great trusts (study what Marx's friend F. Engels wrote about British and American trusts and how "the people" would not entrust their fate to a group of "dividend mongers."). Schumpeter later drew out the implications of Western political trends expertly in "Capitalism, Socialism, and Democracy" (1942).
"The Theory of Economic Development" was the first of the bookends in Schumpeter's grand vision. Upon grasping the dance of our modern mavens -- to use a title close to one of Joan Crawford's early films -- your understanding of economics will never be the same.

Many innovation researcher always cited famous sentence from this book. Innovation is defined as the introduction of new goods, methods, market, source of supply, and organization. Few researcher, however, told so what. This valuable title is still available. Great treasure.

I read Schumpeter's "History of economic analysis" a couple of months ago so I decided dive into this other important contribution. I must admit, it wasn't nearly as interesting and took some real effort. The other reviews listed go over his important points about the business cycles but what I enjoyed about "History" was his style of writing that was witty, down to earth and very sharp. This book seemed to be the opposite. Not my favorite.

Length:: 9:33 Mins

Zachary Zeisler's review was made as part of a critical review assignment for the Spring 2009 Economics of Technology seminar at the University of Nebraska at Omaha, taught by Art Diamond. (The course syllabus stated that part of the critical review assignment consisted of the making of a video recording of the review, and the posting of the review to Amazon.)