It is widely known that Charles Darwin’s theory of evolution was of groundbreaking scientific importance, ranking alongside Isaac Newton’s discovery of gravity and the laws of motion, or Copernicus’s realization that the earth revolves around the sun. Few realize, however, that Darwin may never have come to his epiphany were it not for economics.
In 1838, Darwin was inspired by writings of Thomas Malthus (see The Malthusian trap) to imagine a world in which the fittest survive and can evolve into new, more sophisticated and better-equipped species. “I had at last,” he said, “got a theory by which to work.” And when you look at them, the forces that shape both the natural world and free-market economics are uncannily similar.
Law of the economic jungle Like nature, free markets can be nasty. They sometimes cause talented and worthy individuals to fail. They are unforgiving: if an idea of yours does not succeed it can mean bankruptcy; if you make a bad investment you could stand to lose everything. However, according to the law of creative destruction, such failures can ultimately serve to make stronger companies, stronger economies and wealthier societies because they weed out the old, inefficient and most uncompetitive to make way for the new, the vibrant and the strong.
It is an extension of the rules of supply and demand laid down by Adam Smith, but the law of creative destruction, devised by a group of Austrian economists in the 20th century, takes it one step further. It claims that a recession or an economic downturn, in which unemployment rises as firms face falling profits, could, counter-intuitively, be positive for an economy in the long run.
“The process of industrial mutation … incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one … This process of Creative Destruction is the essential fact about capitalism.”
Joseph Schumpeter
Such a claim was made most vigorously by Joseph Schumpeter, an Austrian who emigrated to the United States to escape Nazi persecution. His contention that recessions should not be avoided was as controversial then as it is now. The doctrine supported by most economists at the time (and most politicians even now) was that policymakers should do whatever possible to avoid recessions and, in particular, depressions. John Maynard Keynes notably argued that these cause such significant collateral damage, in terms of unemployment and slumping confidence, that they should be countered by every means at a government’s disposal, such as cutting interest rates and spending public funds to kick-start the economy.
Most economists typically rely on complex computer models that assume competition is perfect and supply and demand remain more or less static over time. Schumpeter claimed that such models bear little resemblance to the volatile conditions in which societies are forged.
Schumpeter’s argument, far from being quashed, has retained its strength. In fact, according to prominent economists Brad DeLong and Larry Summers, just as Keynes was the most important economist of the 20th century, Schumpeter may well prove to be the most important of the 21st.
Schumpeter hailed originally from what is now the Czech Republic, but moved to Vienna, Austria, when his mother remarried. There, his aristocratic stepfather helped him gain entrance to elite colleges, where he soon stood out as a brilliant student. Indeed, not long afterward he embarked on a remarkably illustrious career: first as professor of economics and government at a number of universities, and then, after the First World War, as Austrian Minister of Finance, finally becoming president of Biederman Bank in 1920. However, the bank collapsed in 1924, leaving Schumpeter bankrupt and forcing him back into academia. With the rise of Nazism in the 1930s he moved to America, where he was fast recognized as a top intellectual. He spent the rest of his career at Harvard, gaining something of a cult following among students and professors alike. He was, by the 1940s, one of America’s most renowned economists, becoming president of the American Economic Association in 1948.
Rebirth through recession Rather than rolling along at a constant rate, economies are prone to so-called cycles of boom and bust (see Boom and bust). During a boom, when consumers are spending more than usual and often borrowing more, it is comparatively easy for businesses to make money. Schumpeter argued that this leads to inefficient firms that, in less favorable times, would not even have been formed in the first place.
Conversely, when the economy slumps and people spend less, inefficient companies go bankrupt. While this causes pain in the short term, it also forces investors to put their money into other, more attractive parts of the economy. This in turn boosts the potential growth rate for the economy in the years ahead. Schumpeter and his fellow Austrian, Friedrich Hayek (see Individualism), thus argued that governments should not slash interest rates massively to prevent recessions. Instead, they argued, those who made unprofitable investments during booms should suffer the consequences, or else the same mistakes would invariably be made in the future.
Such logic applies to entire industries as much as individual firms. For example, lean times in recent years, brought about by competition from overseas, have forced manufacturing industry in the United States and Europe to contract and become more streamlined, inefficient firms having been weeded out.
Survival of the fittest The theory was put into practice during the Great Depression of the 1930s, when US policymakers allowed thousands of banks to collapse, hoping for a cathartic recovery. US Treasury Secretary at the time, Andrew Mellon, urged investors to “liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate … It will purge the rottenness out of the system.” In the following years, the economy lost a third of its wealth and took decades to fully recover. That hardly seems like a creative type of destruction and, unsurprisingly, the idea subsequently fell out of favor. Recent studies showing that firms are often more likely to restructure and streamline during boom times rather than in busts have reinforced skepticism.
Schumpeter and Hayek, however, argued that there is an important difference between a shallow downturn and a full-blown depression, which lasts for years and causes irreparable damage. In addition, for the creative destruction rule to work, economies must be flexible enough to cope with the ebbs and flows caused by downturns. In many European economies where labor markets are strictly regulated and it is difficult for firms to hire and fire, it may be harder than it ought to be for those who have lost their jobs in a downturn to find employment again. In such cases, recessions can have a permanent cost that outweighs the longer-term benefits promised by creative destruction.
“Economic progress, in capitalist society, means turmoil.”
Joseph Schumpeter
The lasting message is that out of the ashes of an economic slump can come a stronger and healthier economy. Of the top 100 global companies in 1912, only 19 remained in the list by 1995, with nearly half having disappeared, collapsed or been taken over. However, it is precisely because of creative destruction that the economy has grown so successfully in that period. Research shows that most recessions in American history have tended to improve productivity rather than dampening it. So, just as evolution over time leaves species better equipped to adapt to their environment, creative destruction has created better functioning economies.
the condensed idea
Companies must adapt or die
| timeline | |
|---|---|
| 1883 | Joseph Schumpeter born |
| 1930s | Great Depression causes hundreds of thousands of business failures |
| 1942 | Schumpeter popularizes the idea of creative destruction in his book Capitalism, Socialism and Democracy |