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

The book was originally written during the Great Depression to offer a peek into the future as seen by a widely admired economist. It is heavy going, not light reading, but does provide an excellent analysis of the perils to democracy if capitalism and socialism fail to properly address economic problems. The author warns that government interference in the market place is not the correct answer. His most interesting thesis seems to me to be that unfettered capitalism will fail due to its very economic success because critics will fail to remember the basic tenets that led to that success. Schumpeter gives us a good look at recent U.S. economic history but critics will not like what he implies.

This book is a complex and systematic sociological discussion of the evolution of industrial economies in the pre-1945 era. It also includes a summary of Karl Marx's theories, to help the reader follow the contrasts that Schumpeter draws between his observations and Marx's. It concludes with a number of sections containing Schumpeter's views on contemporary political economy from the perspective of the dates of the book's three editions: 1942, 1947, and 1949.

It's written conversationally, with enough grace to draw the reader along in a complex argument sustained through a number of chapters. Nonetheless, the author's self-indulgence also comes through: he pontificates and where he has nothing to say he says that a long book does not afford enough space to contain his argument. That's okay, I wouldn't have wanted it to be longer than it is.

This style works when you're right, and Schumpeter was magnificently right about one of those key facts that everyone can see instantly once attention is drawn to it: that the long-term growth that transforms living standards does not and cannot proceed by increasing the amounts of things produced, but instead must result from the introduction of new products and processes. Schumpeter connects product innovation with the efforts of individuals but concedes that it can be systematized also, which should have comforted him as he could see that the enterprise sector was becoming bureaucratized.

Schumpeter's second outstanding observation is surprisingly less often remarked: he laid out what later came to be called the "New Institutional Economics," showing why taking into account that private enterprise is essentially only semi-competitive, based on uniqueness of product innovation among other things, changes completely the normative evaluation of market structure and public policy. Mainstream economics taught Chamberlin-Robinson "monopolistic competition" as an oddity but otherwise ignored this point for decades, entertaining itself by re-doing outmoded Marshallian analysis using the mathematics of perfect gases. (I know this sounds strange, but you could look it up.)

Schumpeter also has intriguing observations on democracy, although by not measuring his thoughts against his contemporaries' he doesn't help us see where he is contributing. He characterizes democracy as being essentially competitive rather than ethical, and in chapter XXIII he lays out five reasonable "Conditions for Success of the Democratic Method." One might wonder whether any of them obtain in the U.S. at present.

It is on socialism where I and other readers feel he stumbles. His sarcasm about centralized, comprehensive socialist economic planning may be well founded in terms of feasibility, but it's unworthy rhetorically -- although the fact that economists went on trying to lay the bases of comprehensive planning (Lange-Lerner; Arrow-Debreu) may suggest that there was a reason for Schumpeter's frustration.

Like his treatment of socialism, Schumpeter's supposed prediction of capitalism's demise is largely rhetorical. First, Schumpeter defines capitalism as what we might almost call "Robber Baron" capitalism, whose primordially entrepreneurial firms he indeed predicts (or post-dicts) will be socialized, but through the stock market rather than by Bolsheviks. Second, his argument about the end of private ownership in general is not a prediction but rather a provocation: a warning about what might happen if then-current trends persisted.

With his concern about comprehensive public ownership, Schumpeter failed to take seriously the mixed economy. Since Schumpeter's time, technical economic analysis has helped identify the specific sectors, within a private-ownership economy, that may need "socializing" in some sense (think basic medical services), based on concepts like public goods and incentive compatibilities. Schumpeter missed that boat altogether.

Like Marx, Schumpeter predicts the inevitable disintegration of the capitalist system. However, where Marx foresees the collapse as stemming from proletariat revolution, Schumpeter argues that the "actual and prospective performance" of capitalism is strong, and unlikely to fail. But, Schumpeter argues, it is these same successes which will ultimately destroy the social institutions, namely private property and free contracting, necessary for its continued survival. As such, new conditions will emerge which will not allow capitalism to continue and socialism will become the dominant economic system.

Capitalism is an evolutionary and dynamic process. This constant state of motion is driven by the emergence of new methods of production (and subsequently new consumer goods), the pursuit of new markets, and improved forms of industrial organization (83). As such, aspects of the internal capitalist system are constantly being revolutionized; old processes are being replaced with new processes in the name of progress and improvement. Schumpeter refers to this process as a state of creative destruction. "This process of creative destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has to live in" (83).

The theory of creative destruction is based on the classic feature of capitalism, competition. Traditionally, capitalism is characterized by competition stemming from price, methods of production, and organization. This competitive attributes help to ensure the market efficiency of firms. However, Schumpeter argues that the real feature of capitalism is destructive competition. Destructive competition includes the emergence of new commodities, technologies, sources of supply and new types of organizations (84). Where the traditional measures of competition allow for existing firms to evolve in a changing market, destructive competition tends to destroy those firms which become inefficient. It is this system of destructive competition that revolutionizes the internal capitalist structures.

Through the process of destructive competition, Schumpeter argues that the vital institutions of capitalism, ownership of property and freedom of choice in contracting, are destroyed. Schumpeter's sentiment is illustrated through a brief examination of the collapse of the feudal structure. During the feudal period, changes in production and mechanization overran and obliterated the artisan and small producer. Today, the same process can be observed in that larger, more efficient firms are eliminating their smaller, less efficient brethren. Stated simply, the capitalist process attacks its own institutional framework. The entrepreneurial class, which fuels the dynamic capitalist system, is being retarded, or as Schumpeter suggests, "economic progress tends to become depersonalized and automatized" (133).

This is exemplified by the emergence of mega-companies in which the firm is rarely owned by one individual but rather is composed of board members and stock holders. Schumpeter argues that none of these actors truly own the company and as such lack the drive of the entrepreneur who owns his or her company. What then emerges is capitalist stagnation. Individual choice is usurped by the interest of large corporations. Instead of relying on choice, corporations will come to agreements between themselves, thus creating a system of pseudo-monopoly. With this limited competition, laws and regulations are imposed on the corporations rather than left to individual firms (141). As such, we begin to see the emergence of socialist ideology in that competition and ownership are removed, and replaced by a centralized governmental system of control.

Of particular note, unlike Marx who sees the destruction of bourgeois entrepreneur as a necessary precondition to socialism, Schumpeter sees the same entrepreneur as integral to the success of the socialist transition. Socialism will only emerge when capitalism has reached its maturity, that point in time where capitalism has destroyed its own vital institutions of ownership and choice. Although these institutions are eliminated, socialism still reaps the benefits from the technology, knowledge, and resources developed by the entrepreneurial class in the earlier stages of capitalism. In order to be sustainable such inheritances are necessary condition for the success of socialism.