Capitalism, Socialism, and Democracy: Third Edition Paperback – November 4, 2008

This is one of the most important books on Capitalism ever written. Unlike most economists, Schumpeter's knowledge and understanding of the sociological & political sides of the capitalist process was just as profound as was his knowledge and understanding of the economic side. Consequently, he presents a more well-rounded view of Capitalism than we usually get from the typical one-dimensional type of economist.
Most economists commit the fatal error of regarding capitalism as a mere economic phenomenon, explicable by economic laws alone. But this view is palpably erroneous. Capitalism both influences and is influenced by political and sociological factors. Any account of the Capitalist system which ignores these non-economic factors must be regarded as short-sighted and incomplete.
This book is probably most famous (or most infamous, depending on your point of view) for its prediction (circa. 1942) that capitalism would eventually be replaced by some form of socialism. With the collapse of communism in Eastern Europe and the revival of market economics in East Asia and South America, it might appear that Schumpeter's prediction has been refuted. But this conclusion would be premature and superficial. Keep in mind Schumpeter's broad vision of capitalism. For Schumpeter, capitalism is much more than a free market acting under the guidance of supply and demand and consumer sovereignty. In Schumpeter's vision, capitalism is entire order of civilization, embracing the old-fashioned "bourgeois" code of ethics (see Thomas Mann's "Buddenbrooks" for a concrete illustration of bourgeois civilization) and entrepreneurial innovation (or "creative destruction," as Schumpeter calls it in his famous theory of the business cycle). When Schumpeter predicted that socialism would ultimately triumph over capitalism, he did not mean that a perfectly controlled economy would replace a perfectly free market, but that a "socialist" civilization would replace the capitalist civilization of the 19th century. His prediction, although not correct in all respects, is nevertheless prescient in a number of important ways. The social order prominent in the first world today is capitalist more in form than in substance. The corporation, which is regarded as a public institution by the law, is the dominant economic unit. Privately owned businesses have less and less power in the market. Regulation and state involvement in business are more and more common. Schumpeter once said that when socialism came to America, it would not be called socialism. This remark comes uncomfortably close to hitting the nail on the head.

Capitalism, Socialism, and Democracy is divided up into five main sections. The first section on Marx and the last section on the history of the socialist parties in Europe can be safely skipped by most readers. The three central sections on capitalism, socialism, and democracy are definitely the heart of the book and of the three central sections the section on capitalism is by far the most interesting.

In the section on capitalism Schumpeter really tries to do two things. First, he attempts to provide a defense for capitalism based on its dynamic nature. Schumpeter is critical of the defenses of capitalism which base themselves on the notion that under perfect competition "the profit interest of the producer tends to maximize production" (pg77). In two footnotes Schumpeter explains the problems he has with this standard defense of capitalism.

In the first he writes, "The principle, as far as it can be proved at all, applies to a state of static equilibrium. Capitalist reality is first and last a process of change. In appraising performance of competitive enterprise, the question whether it would or would not tend to maximize production in a perfectly equilibrated stationary condition of the economic process is hence almost, though not quite, irrelevant" (pg77). The standard defense relies on the notion that under perfect competition (a state in which prices are parameters and not variables) production will take place up until the point that marginal cost just equals price. It is further argued that this is precisely "as much as it is in general `socially desirable' to produce" (pg78). But as Schumpeter points out in his footnote this only takes place when the economy is in a state of static equilibrium. Since a capitalist economic system is never in such a state the defense becomes (almost) irrelevant.

In the second footnote Schumpeter is responding to a closely related theorem, namely, the theorem that competitive industry tends to produce a maximum satisfaction of wants. Schumpeter writes, "this theorem, even if we waive the serious objections to speaking of non-observable psychic magnitudes, is readily seen to boil down to the triviality that, whatever the data and in particular the institutional arrangements of a society may be, human action, as far as it is rational, will always try to make the best of any given situation. In fact it boils down to a definition of rational action and can hence be paralleled by analogous theorems for, say, a socialist society" (pg77). Utlimately the defense of capitalism which rests on the notion that perfect competition leads to a maximum satisfaction of wants boils down to the proposition that given any set of parameters (consumption preferences, capital allocations, technical levels, etc.) human beings will tend to make the most that they can with what they have. This applies to any institutional form and is not specific to capitalism.

Schumpeter offers a different (and in my opinion a better) defense of capitalism by pointing to its dynamic character. Schumpeter argues that capitalism is a process which is constantly engaged in revolutionizing the means of production (creative destruction) as entrepeneurs seek `super profits'. This dramatically increases the total output of society and a huge share of this increased output winds up finding its way to the lower classes of society. As Schumpeter says, "There are no doubt some things available to the modern workman that Louis XIV would have been delighted to have yet was unable to have...On the whole, however, a budget on that level had little that really mattered to gain from capitalist achievement" (pg67). The Louis XIV's of the world are not primarily the ones who benefit from the dynamic of the capitalist system since the capitalist system is overwhelming geared towards mass production and so produces goods that can be consumed cheaply by the masses. This defense of capitalism does not rely on any theorems about maximizing utility under perfect competition and is a far more realistic defense of the advantages of a social system that is ruled by the profit motive.

The second goal of Schumpeter's section on capitalism is to describe the ways in which the processes unleashed by capitalism tend, inexorably, to undermine its own foundations. The most interesting example of this is the way in which property comes to be redefined through the joint stock company. There is a separation of ownership and management. The role of the entrepreneur also begins to erode as the process of creative destruction becomes mechanized and standardized. Instead of the adventurous entrepreneur taking a chance on a new idea we have corporations and their programs of research and development. One of the great virtues of Schumpeter's work is that he manages to avoid viewing things from a restrictively economic standpoint and is able to see the importance of sociological factors in determining the behavior of the economic sphere. So Schumpeter also spends some time discussing sociological changes brought about by capitalism which in turn have an effect on the economic process (family relations for example)

In the section on socialism Schumpeter attempts to work out a logical blueprint for a socialist society that would be capable of solving all the problems that a free-market is able to solve (the allocation of capital, provision for public goods, incentives and motivations for workers and managers, etc.). Schumpeter attempts to argue that there is at least no logical reason why socialism could not work. I am not sure he is entirely successful but this section is at least thought provoking and indicative of the problems that socialists necessarily face in constructing an alternative social arrangement for production and distribution.

In the final section on democracy Schumpeter attempts to reconceive democracy as a competition for political leadership. Democracy is not the rule of the people for Schumpeter, rather, democracy is "the rule of the politician" (pg285). Public policy, on this view, becomes merely a by-product of political competition. This is probably a more realistic picture of how democracy really works then the standard view but it relies on the notion that human beings have far less awareness and knowledge in regard to affairs that do not concern them directly, or that they do not deal with on an everyday basis, and, therefore, do not have strong opinions one way or another. They can be swayed by politicians. In other words, this is not necessarily an analysis of the `eternal' nature of democracy. If human beings were to achieve a better grasp of social issues this vision of democracy might not apply.

In summary, this book is definitely worth reading. Although the first and last sections can be skipped and if you are really in a hurry you can simply read the section on capitalism and you definitely will have read the most interesting and the most influential section of this work.