How the Modern Economies Got Their Dynamism
The secret of brilliant productivity will always be discovering new problems and intuiting new theorems, which open the way to new results and connections. Without the creation of new viewpoints, without positing new aims, mathematics would soon exhaust itself in the rigor of logical proofs and begin to stagnate, as it would run out of content. In a way, mathematics has been best served by those who distinguished themselves more by intuitions than by rigorous proofs.
FELIX KLEIN, Lectures on Mathematics in the 19th Century
PART ONE SEES THE FIRST MODERN ECONOMIES as lying at the core of the modern societies that arose in the West early in the 19th century. Their unprecedented dynamism was mirrored by dynamism in other realms of society as well. The narrative describes how these economies changed not only living and working standards but also the very character of life: dynamism manifests itself in manifold ways. The narrative goes on to examine how and why these history-making economies came about.
A modern economy, as that term is used here, means not a present-day economy but rather an economy with a considerable degree of dynamism—that is, the will and the capacity and aspiration to innovate. One may ask, then, what makes a modern economy modern, just as one may ask what makes modern music modern. If a national economy is a complex of economic institutions and a fabric of economic attitudes—an economic culture—what structure of these elements equipped and fueled the modern economies for dynamism? To begin, it is necessary to be clear about the concept of dynamism and its relation to growth, with which it is often confused.
Innovation, Dynamism, and Growth
An innovation, to repeat, is a new method or new product that becomes a new practice somewhere in the world.1 The new practice may arise in just one nation, before it spreads, or in a community that cuts across nations. Any such innovation involves both the origination of the new thing—its conception and its development—and the pioneering adoption. Thus innovations depend on a system. Innovative people and companies are just the beginning. To have good prospects for innovation, a society requires people with the expertise and experience to judge well whether to attempt development of a new thing; whether a proposed project is worth financing; and whether, when a new product or method is developed, it is worth trying.
Until recent decades, the innovation system was supposed to be the national economy. To innovate, a nation had to do its own development as well as its own adoption. But in a global economy, in which national economies are open to outside developments, the development could take place in one country and the adoption in another. If an innovation, joint or singlehanded, is then adopted by another country, that adoption is not regarded as an innovation—not from a global perspective. Yet selecting foreign products that would have good prospects of acceptance at home might require as much insight as selecting among new conceptions to develop. The distinction between innovation and imitation is basic, but the line between may be fuzzy.
We must also understand the concept of an economy’s dynamism. It is a compound of the deep-set forces and facilities behind innovation: the drive to change things, the talent for it, and the receptivity to new things, as well as the enabling institutions. Thus dynamism, as it is used here, is the willingness and capacity to innovate, leaving aside current conditions and obstacles. This contrasts with what is usually called vibrancy: an alertness to opportunities, a readiness to act, and the zeal to “get it done” (as Schumpeter puts it). Dynamism determines the normal volume of innovation. Other determinants, such as market conditions, may alter the results. And there can be a drought of new ideas or a gush of them, just as a composer may have a dry or fertile spell. So the pace of actual innovation may exhibit marked swings without any change in dynamism—in the normal tendency to innovate. Post-war Europe saw a sprinkling of innovation in the 1960s —the bikini, the Nouvelle Vague, and the Beatles, for example. By 1980, though, with wealth having recovered to its old level relative to income, innovation had fallen back. It became apparent that the dynamism of Europe had not recovered, even partially, to its healthy level in the interwar years, although that became clear only with mounting evidence.
One way to measure this dynamism is to gauge the aforementioned forces and facilities—the inputs producing dynamism. Another approach is to gauge the size of its estimated output: the average annual volume of innovation in recent years—the growth of total GDP not attributable to the growth of capital and labor—after allowance for unusual market conditions and after deducting the “false innovations” copied from other countries. The decadal average income earned by those in the innovation process, if we could observe it, would be a crude measure of that “output.” Or we could size up many strands of circumstantial evidence: new firm formation, employee turnover, turnover in the 20 largest companies, turnover of retail stores, and the mean life of a product’s universal product code.
The economic growth rate of a country is not a useful measure of dynamism. In a global economy driven by one or more economies of high dynamism, an economy with low or even no dynamism may regularly enjoy much the same growth rate as that of the highflying moderns—the same growth rate of productivity, real wages, and other economic indicators. It grows that fast partly by trading with the highflyers but mainly by being vibrant enough to imitate the adoptions of original products in modern economies. Italy provides a nice example: from 1890 to 1913, output per manhour there grew at the same rate as in America—it remained 43 percent lower, neither gaining nor losing ground in the league tables (the rankings of countries by the relative levels of their productivity (e.g., output per hour worked) and real wages), but no economic historian would suggest that Italy’s economy had much dynamism at all, let alone the American level.
An economy with low dynamism might for a time show a faster growth rate than a modern economy does with its high dynamism. A transient elevation of the growth rate could result from any of a number of structural shifts in the economy, such as an increase in vibrancy or an increase in dynamism from low to not-as-low. While the economy is moving up to a higher place in the league tables—a partial “catch-up” to the modern economies—it will be growing at the normal, global, rate plus a transient, which fades away as the destination nears. But even a growth rate that is the world’s highest should not suggest that the economy has just acquired high dynamism, let alone the highest. Sweden provides a good example. It held the world cup for the championship growth rate of productivity from 1890 to 1913. It started a raft of new companies, several of which endured and became famous. But it did not appear to acquire the high dynamism of America or, say, Germany. In ensuing decades its growth rate dropped below that of America and not one new firm has entered the top 10 on the stock exchange after 1922 even to this day. Japan’s high growth from 1950 to 1990 is another example. Many observers inferred high dynamism, but this streak of growth reflected not the advent of state-of-the-art modernity throughout Japan—no such transformation occurred—but rather the chance to import or imitate practices pioneered for decades by the modern economies. The world-record growth in China since 1978 is the latest example: while the world sees world-class dynamism, the Chinese discuss how to acquire the dynamism for indigenous innovation, without which they will be hard pressed to continue their fast growth.
So a nation’s “dynamism” is not a new word for a nation’s productivity growth. Its own dynamism is not necessary for its growth if the rest of the world has dynamism—vibrancy is enough; and it is not sufficient if the nation is so small that its dynamism cannot go far. Dynamism over an appreciable part of the world leads to global growth, barring bad luck. The modern economies, with their high dynamism, are the engines of the growth of the global economy—today, as in the 19th century.
So, although the growth rate of productivity in an economy—say, output per manhour—over a month or even a year is no indicator of its own dynamism, we might think that the level of its productivity relative to the levels abroad would be an indicator. It is true, with few exceptions, if any, that the economies with productivity levels at or very close to the top level owe that position to a high level of dynamism. Yet a low position of a country’s productivity level may reflect low dynamism or low vibrancy or both. So the relative level of productivity is not an altogether safe indicator of an economy’s dynamism.
To gauge more deeply an economy’s dynamism, we have to look under the hood to see what there is in the structure of an economy that might strongly nourish or inhibit dynamism.
Inner Workings of the Historical Modern Economies
Schumpeter’s near-classical theory, with its concept of punctuated equilibrium, blocked all thoughts of a modern economy—an economy generating economic knowledge through its own talent and insight into the business of innovating. The dominance of this theory has had consequences: to this day, policymakers and commentators do not distinguish between modern economies, less modern ones, and nonmodern ones. They see all national economies, even exemplars of modernity, as essentially machines for producing products and doing so more or less efficiently at that—though some have natural handicaps or costly policies.
But if we just look, we can see the distinctive stuff that modern economies are made of: It is ideas. The visible “goods and services” of the national income statistics are mostly embodiments of past ideas. The modern economy is primarily engaged in activity aimed at innovation. These activities are stages in a process:
• conception of new products or methods
• preparation of proposals to develop some of them
• selection of some development proposals for financing
• development of the chosen products or methods
• marketing of the new products or methods
• evaluation and possible tryout by end-users
• significant adoption of some new products and methods
• revision of new products after tryout or early adoption
In an economy of substantial size, there are gains in expertise from a Smithian division of labor, and innovational activity is no exception: some participants work full-time in a team conceiving and designing a new products, some work in a financial company picking new companies to fund, some work with a start-up entrepreneur developing a new product, some are employees specializing in evaluating new methods, others specialize in marketing, and so forth. No less important, in an economy of dynamism, some portion of most participants’ time is spent looking at current practice with the expectation that a new idea will occur for a better way to do things or a better thing to produce. This patchwork of activity is the ideas sector. In an economy high in dynamism, the idea-driven activity might amount to a tenth of total manhours worked. However, the work of investing in new ideas and new practices—though it may crowd out work in some familiar lines of investment activity—may spark a boundless amount of investment activity aimed at producing facilities to make the new products. The result is a strongly positive effect on employment. (Innovative activity in particular and investment activity in general are far more labor intensive, hence less capital intensive, than the production of consumer goods: food production, for example, uses much capital, such as wire fences, and much energy; energy production also uses much capital, such as derricks, dams, and windmills.)2
How do these modern economies work—those of the 19th and the 20th century too? We may begin at an almost physiological level, rather like Henry Gray’s Anatomy (1862). We see in these modern economies multiple lines of innovative activity. These are parallel efforts, which represent the competition of ideas. In an economy of appreciable size, new commercial ideas are hatched every day, mostly inside enterprises. Development of such ideas will generally require enterprises with the right expertise. Among the projects with an eager entrepreneur, not all will find financial backing. Capital flows only to those projects judged by an entrepreneur and a financial backer to have good prospects of development and marketing. Among the projects carried forward, not all will manage to embody the idea in a product that would be cheap enough to be marketable. Among the new products brought to the market, sales or orders will come in only for those judged by end-users—managers or consumers—to be worth the risk of a pioneering adoption. Only a small proportion will show signs of wide enough adoption to continue production or to warrant stepping up production to break-even or profitable levels. This selection mechanism may leave one idea standing where there were thousands to begin with. (A study by McKinsey estimated that, from 10,000 business ideas, 1,000 firms are founded, 100 receive venture capital, 20 go on to raise capital in an initial public offering of shares, and 2 become market leaders.)
We can picture the corresponding competition going on in a socialist economy: the “enterprises” are state-owned, and the backing comes from a state development bank. We can also picture the corresponding competition in a corporatist economy: the enterprises, though under private ownership, are state-controlled, and their finances are allocated by state-controlled banks. However, the modern economies of the storied past possessed neither one of these structures. The modern economies of the past two centuries—primarily those of Britain, America, Germany, and France—were, and to varying degrees still are, specimens of modern capitalism.
In these real-life modern economies—and in any modern-capitalist economy—decisions to provide capital for the first steps toward innovation are made predominantly by investors, financiers, and share buyers drawing on their own private wealth or by managers of financial companies under private ownership. The collected investments and loans of these “capitalists,” some of them with very small wealth, determine which directions, among those presented, the economy will embark on. Decisions to take the initiative of planning and seeking finance for development of a new idea are made predominantly by producers—managers by trade—starting a private venture or acting within established private enterprises. To distinguish producers of such undertakings from producers of established products, the former are called entrepreneurs. Typically, the entrepreneurs also bring some capital to the new undertaking. Both a project’s entrepreneur and its investors stand to gain whatever pecuniary returns the project might bring and suffer the loss should the returns be negative. Of course, these returns are not determined in isolation: such projects compete against others, driving down the private returns and driving up rents to land and wages to labor. The pecuniary return is not unimportant to an investor with a large stake or to an entrepreneur—their livelihoods and standard of living may be at stake. An entrepreneur may need the prospect of winnings to obtain the moral support of family members.
The prospect of profit, which entrepreneurs and investors share after paying creditors, is not the only prospective return factored into the decision to start a new undertaking. Both entrepreneurs and large-stake investors favor projects that excite their imagination and enlist their energies. They may also want to play a part in the development of the community or the nation.3 (Some entrepreneurs and financiers create enterprises primarily for the satisfaction of producing a social benefit—on top of whatever pecuniary return may be expected. These “social entrepreneurs” may coexist alongside the classic entrepreneurs, whether or not they are financed by the state. To the extent that this parallel system has dynamism, it helps make modern economies modern.)
It is unfortunate that most discussions, except for trivial distinctions like that between ships and factories, do not distinguish modern capitalism from mercantile capitalism (also known as early capitalism or commercial society). Modern capitalism built on early capitalism, of course. The latter solidified property rights; won acceptance of interest, profit, and wealth-building; and taught the social value of individual responsibility. Mercantile capitalism also gave birth (in Venice and Augsburg) to banks that lent to or entered into business. But modern capitalism is as different from mercantile capitalism as innovators are different from merchants. The mercantile economy was about the distribution of products to consumers. (To exaggerate slightly, men and women scooped up nature’s crops and took the excess supplies to market to exchange them for excess supplies of other crops.) Modern capitalism introduced innovation into capitalism. Entrepreneurs soon put merchants in the shade. As new practices welled up, many guilds founded in medieval times could not enforce standards. The state could not issue charters fast enough to meet the exploding demand.
Even more unfortunate, economies around the world that repress competition by limiting entry to the well-connected and do nothing else that might encourage or facilitate innovation are being seen as examples of capitalism by those suffering hardships in those economies as well as those who run the economies. (The American economy is seen as an “exceptional” case of capitalism.) In northern Africa, a tightly connected ring of politicians, elites, and the armed forces keep the business sector for themselves: outsiders are not licensed to enter industries in competition with incumbent enterprises. These economies are said to be “capitalist” on the thought that “capital” is in charge—the wealth of the oligarchy of the ruling families. But a hallmark of capitalism is that the capitalists are independent, uncoordinated, and competing with one another: no monarchy or oligarchy is in charge. And a hallmark of modern capitalism is that it permits and invites outsiders with a new idea to seek capital from capitalists willing to place a bet on the proposed project. These oligarchic economies are more accurately viewed as a kind of corporatism, a system in which the business sector is under some kind of political control.
This chapter began by asking what structure “equipped and fueled” the modern economies for dynamism. The discussion so far has cast some light on how the modern economies are equipped to select among new ideas for development and adoption. But what fuels the creation of new ideas?
The very concept of new economic ideas has been foreign to the rising numbers under the spell of scientism, which came to rule academia in the 20th century—not to mention historicism, which ruled out any new ideas! As noted in the Introduction, the German Historical School supposed that only scientists have new ideas, which, after testing, often add to scientific knowledge. That theory never worked well: from the time of Columbus to Isaac Newton’s era there was little innovation and between the steam engine and electric power there was no epochal scientific advance. But the failure of a theory is not enough to stop it. Schumpeter, some 30 years after his first book, reaffirmed that only scientists can have ideas, allowing that they could have their ideas in the great industrial labs, such as DuPont.4 The popular theory today is neo-German: gifted conceivers of new technology “platforms,” such as Tim Berners-Lee, creator of the World Wide Web; Jack Kilby and Robert Noyce, the builders of the microchip; and Charles Babbage, inventor of the computer, are thought to provide the underlying advances that make possible successive waves of applications. This scientism easily persuaded the public. No one had to ask where scientists and engineers “get their ideas,” since everyone knew they got their ideas from their observations in the lab and the findings reported in research journals. The investigators and experimenters are immersed in their science and engineering fields—though no more than entrepreneurs and financiers are immersed in their fields.
But the advent of the modern economy brought a metamorphosis: a modern economy turns people who are close to the economy, where they are apt to be struck by new commercial ideas, into the investigators and experimenters who manage the innovation process from development and, in many cases, adoption as well. (In a role reversal, scientists and engineers are called in to assist on technical matters.) In fact, it turns all sorts of people into “idea-men,” financiers into thinkers, producers into marketers, and end-users into pioneers. The driving force of the modern economy in the past two centuries is this economic system—a system built of an economic culture as well as economic institutions. This system, rather than the brilliant personaggi of the popular theory, generates the modern economy’s dynamism.
The modern economy, then, is a vast imaginarium—a space for imagining new products and methods, imagining how they might be made, imagining how they might be used. Its innovation process draws on human resources not utilized by a premodern economy. In Schumpeter’s theory, premodern development draws on the capacities of premodern entrepreneurs to organize the projects made possible by outside discoveries—he spoke of human resources like hustle and the determination to “get the job done.” As modern theorists have said, modern entrepreneurs are business owners or managers who, in the face of not very much real knowledge, micro or macro, demonstrate “a capacity for making successful decisions when no obviously correct model or decision rule is available”—nor can be—as a 1990 essay by Mark Casson put it. This capacity, which relies on financiers as well as entrepreneurs, is recognized to require the resources called judgment, or acumen—judgment about the unknown likelihood of things—and wisdom—the sense that there are forces not even conceived of, called the unknown unknowns. This judgment involves imagining in an effort to foresee the consequences of alternative actions. This entrepreneurial capacity is modern entrepreneurship. But it is not by itself a source of radical change or even novelty. It is not the same as innovatorship.
The indigenous innovation process of the imaginarium draws on a different set of human resources. A basic resource is the imaginativeness, or creativity, to conceive of things not conceived already that a firm could try to develop and market. There cannot be much departure from present knowledge if no one can imagine the existence of another way or another goal, or if no one can imagine the chance of beneficial outcomes. Imaginativeness is fundamental to successful change, as David Hume saw in his profound work so fundamental to the modern era.5 The innovative capacity also requires insight—insight into a new direction that might turn out to meet desires or needs that could not have been known before. That insight is often called strategic vision—an intuition we cannot explain and a sense of whether other enterprises will be adopting the same strategy. Steve Jobs owed his huge success to his creativity and deep insights. Curiosity to explore and the courage to do something different must also be mentioned.
Yet no imaginarium will be present in economies where people are not motivated and encouraged to innovate or are not in a position to innovate. The fuel on which this system operates is a mixture of pecuniary and nonpecuniary motives. Pecuniary rewards make a difference: The prospects of significant money are apt to be helpful in persuading one’s family to support the effort one may have to put in. So few participants in the economy will be available to conceive and develop a commercial idea if not legally free to monetize it—to sell it to an entrepreneur for a share of the resulting profit or, in the case of patentable concepts, to collect the royalties under the patent or sell the patent to others. Entrepreneurs and investors will not develop an idea if they are not legally free to start a firm, break into an industry, sell their shares in the firm later (nowadays in an initial public offering), and close down the company in the event that buyers do not turn up. Entrepreneurs have to know that potential end-users are free to abandon a current method or product in order to cast their lot with a new method or product. Without the incentive of such pecuniary protections and inducements, most entrepreneurs will draw back from undertaking such ventures, no matter the nonpecuniary rewards.
Some nonpecuniary motives, or drives, are also important—perhaps critical—for the functioning of the modern economy. To function, the modern economy feeds off a motivating economic culture as well as pecuniary incentives. High dynamism in a society requires people who grew up with attitudes and beliefs that attract them to opportunities that they expect will excite them with their novelty, intrigue them with their mysteries, challenge them with new hurdles, and inspire them with new vistas. It requires people in business brought up to use their imaginativeness and insightfulness to achieve a new direction; entrepreneurs driven by their desire to make their mark; people in venture investing willing to act on a hunch (“I like the cut of her jib”); and many end-users—consumers or producers—with the willingness to pioneer the adoption of a new product or method whose expected value is not knowable beforehand. This requires drives such as aspiration, curiosity, and self-expression. High dynamism in the system requires high dynamism in all its parts.6
Innovating also draws on people’s observations and personal knowledge. New business ideas come only to those who have been observing at close hand some area of a business, learning things about how it works and giving some thought to the possible size of the market for a new sort of product in that area or to the prospect for a better method of production; plausible business ideas rarely come to those remote from any business. People situated in some area of the business sector will gain knowledge and see opportunities that they would not otherwise have been aware of—or have known existed.
Hitting upon an idea for better use for retail space or a better route for delivering packages is not exactly what we mean by innovation. Yet, it may be argued, the detailed business knowledge that inspires new ideas for business investment also inspires ideas that may lead to business innovation. (Similarly, the attitudes that help stir the formation of new investment ideas also stir ideas for innovation.)
So there is an obvious answer to the question of where business people’s ideas for innovation come from: they come from the business sector. Business people draw on their personal observation and private knowledge, in combination with the shared pool of public knowledge (such as economics), in coming up with conceptualizations that lead to a new method or product that might “work”—much as a scientist, immersed in his or her own experimental data, specialized expertise, and general scientific knowledge, arrives at a new formulation or hypothesis to be tested, which might add to scientific knowledge. Business people and scientists alike draw on private knowledge, based on individual observation, as well as on the public knowledge of the community to which the individual belongs. (Yet scientists will undoubtedly go on believing that business people get their ideas from outside business, just as most people say that composers get their ideas outside music. Giving the lie to this common illusion, Robert Craft reported an exchange between reporters and Igor Stravinsky: “Maestro, can you tell us where you get your ideas?” “At the piano,” Stravinsky shot back.)
Friedrich Hayek, the Austrian-born economist who loomed large in the Austrian school, was the first economist to view economies from this perspective. His seminal works from 1933 to 1945 see producers and buyers in the complex economies around him as having valuable practical knowledge about how best to produce and what best to produce. Typically, such knowledge, being local, contextual, and kaleidoscopic, cannot be easily acquired by or communicated to others: it remains private knowledge. (Even if all of it were all costlessly accessible—open to the public—it is too enormous to be comprehended, let alone assimilated.) Therefore such knowledge is, and remains, dispersed over the economy’s participants, each industry having much knowledge unique to the industry and each participant some further knowledge unique to that individual or to a very few. This leads to two propositions: First, an economy of complexity gains critically from markets, in which individuals and companies can exchange goods and services with one another, so that the specialization of practical knowledge can continue—so one does not need to be a jack-of-all-trades with only the thinnest knowledge of any. When new knowledge is obtained in an industry, this is “communicated” to society through the market mechanism: a drop in price, or the like. Second, such an economy, if unimpeded, is an organism ever-acquiring gains in economic knowledge of what and how to produce (while also deaccessing old knowledge once it is of no further use). The right prices are “discovered” in the process. Every company or participant is like a forward observer, or scout ant, responding alertly with adjustments in the level or direction of production to observations and analyses of any local development. If the output of some product is increased, the reduced price on the market will signal the society that it now costs less than before.7 This was Hayek’s knowledge economy.
Yet this work of Hayek is not about innovations. It does not envisage indigenous innovations, which develop from ideas sparked by the creativity of participants in the economy. In a much-cited 1945 paper, he makes it explicit that he is discussing adaptations—“adaptations,” he calls them, to “changing circumstances.” These adaptations do draw on some of the human resources of modern entrepreneurship mentioned earlier: judgment, and wisdom, and the drive to make their mark.
There is an air of predictability about adaptations, unlike innovations. They do not involve an intuitive leap but are repercussions that would take place sooner or later, barring some other change that erased the need for the adaptation. And they will not go on long if “circumstances” should stop “changing.” They are not disruptive: they bring closure to a disruption rather than causing new disruptions. In contrast, innovations (from nova, Latin for new) are not determinate from current knowledge, thus are not foreseeable. Being new, they could not have been known before. Yet many business people have the mistaken notion that innovation means going out to find out what their customers want. The fallacy that innovations are foreseen is criticized by Walter Vincenti:
The “technical imperative” of the retractable landing gear is … after-the-fact. Designers at the time, by their own testimony, did not foresee it.… Innovators see where they want to go and by what means they propose to get there. What they cannot do, if their idea is novel, is foresee with certainty whether it will work in the sense of meeting all the relevant requirements.8
Being unforeseen, an innovation may be disruptive, creating a new jigsaw puzzle in which to fit the pieces—to which to adapt. Innovations are the happenings to which “adaptations” adapt. (A big adaptation that comes far sooner than supposed could be disruptive.) An innovation may be ephemeral, yet most innovations tomorrow stand on the shoulders of today’s innovations. Cumulatively they drive the economy’s “practice” on a path to ports-of-call that would otherwise have gone unseen. Thus innovations pass a more demanding test than adaptations do.
Innovations, while requiring the intellectual faculties of imaginativeness and insight to envision a new objective, may also require the boldness to venture into unknown territory and thus to go in a different direction from one’s peers and mentors. This causes us to see innovators as heroes—putting creation ahead of their comforts and braving failure and losses. However, there is no reason to think that innovators love risk. The Minnesota innovators Harold and Owen Bradley said that an innovation springs from conceiving a new model of the business or of the world in some respect. So it may be that innovators, whether the founders of companies or gifted CEOs or the pioneer end-users, are driven by an inner need to demonstrate to themselves or to others the superiority of their understanding.
Henry Ford’s quest for the mass-produced car is a paradigm case of innovation. In the 2011 lecture “Eureka,” Harold Evans told the story:
Many Americans believe Henry Ford invented the car. Of course, he was preceded in Europe and by others in America and even in his home town of Detroit. He said: “I invented nothing. I simply assembled into a car the discoveries of other men.” In fact, he did do something startlingly new. Not so much in originating the automatic production line; an assembly line that multiplied milling productivity fivefold was devised by Oliver Evans in 1795 … Henry Ford’s genius lay in an idea—the egalitarian idea that everyone should have a car.
Although some people did not view Ford as highly innovative, like Ford himself, his breakthrough was a farsighted vision of a new way of life, which he proved realizable. Another instructive story is America’s glorious cross-country railroad. Evans’s 2004 book They Made America discusses it:
Theodore Judah, of Sacramento, had the boldness to entrepreneur and engineer America’s first transcontinental railway. His wife Anna wrote that “it … show[ed] what was in the man … to grasp the gigantic and the daring.” Detractors said that the idea had been around for years and it was “just a matter of time” till the railway was built.
As Evans remarks, Judah’s engineering feat was felt by some to be too foreseeable to be classed as an innovation. Yet it was only the attempt at construction that was “just a matter of time.” Success was in doubt. Many engineers thought that such a direct railway to northern California was not feasible. So the successful construction was by no means foreseeable. Judah had a stunning intuition and proved he was right.
Some innovations are accidental. Thomas Edison absent-mindedly created a filament out of some tarred lampblack in his hand, and Alexander Fleming made penicillin by mistakenly leaving a Petri dish uncovered. In the economy, too, there are countless examples of an undreamed innovation. There is always some “Side B” or low-budget sleeper that becomes an unimagined hit. Pixar was created to develop a new computing practice, but when a technician showed some visitors he could use the technique to make animated cartoons, their excitement turned the company into an animation studio. These accidental innovations were so novel that the conceivers did not even dream of the new product.
And virtually all innovations have an accidental or random element. Success in developing the new product and gaining adoption for commercial production is in part a matter of chance. The iconic TV interviewer Larry King commented more than once that his most famous guests all told him that their enormous success depended on a stroke of good luck. Yet the success or failure in attempted innovation is not like a lucky or unlucky flip of a known coin. Innovators travel on a voyage into the unknown, one with some known unknowns and some unknown unknowns; so they have no way of knowing whether—even with every lucky break—their creativity and intuition will deliver the innovation they hoped for. Hayek, coming finally to innovation in 1961, was dismayed that the American economist John Kenneth Galbraith supposed that companies knew what the prospects were for their new products. For Hayek, a company can no more know the probability of this profit or that loss on a new auto design than a writer of a novel can know what his or her chances are of making the bestseller list.
Oddly enough, economists left it to Hayek to tie up the rudimentary theory he missed starting—though he may have inspired it. In 1968 he sees economies—evidently referring to what is called here the modern economy—producing “growth in knowledge” through the operation of a method he dubs a discovery procedure. The term refers to the process of determining whether the imagined product or method can be developed and, if developed, determining whether it will be adopted. Through internal trials and market tests, a modern economy adds to its knowledge of what can be produced and what methods work, and to its knowledge of what is not accepted and what does not work.9 It might be added that the advance of business knowledge may very well be boundless, since, unlike scientific knowledge, it is not limited by the physical world. It is the scientists who should be worried that their discoveries are coming to an end.
Another source of growth in this knowledge, though this one has limits, comes from correction: the fact that much of current knowledge is incorrect both at the micro level of particular products and the macro level of the whole economy.10 Conditions and structural relationships are apt to be changing in not-yet-perceived ways. (Northrop, using a wind tunnel, found the added drag from a fixed landing gear instead of a retractable one was negligible; they did not realize the added drag was serious on the much faster planes.) In addition, observations of the economy are not outcomes of a controlled experiment; the data themselves are constantly changing as knowledge (and misunderstanding) change in the economy. So there is room in economies for insight into the mistakes of others.
The modern economy takes on “the problem of discovering—or inventing—possibilities and making good use of them,” as Brian Loasby wrote. The more an economy devotes itself to this activity, the more modern it is. An economy can have the vibrancy to formulate, the diligence to evaluate, and the zeal to exploit new commercial opportunities opened by external discoveries, which was as much as Schumpeter could see and thought possible. Yet the same economy or another economy may possess the creativity to conceive its own new commercial ideas in response to conditions or developments within it and have the vision (or intuition) to point that creativity in plausible directions. Creativity and vision are resources; they exist in all human economies. Yet historically some countries were unable or unwilling to deploy them and others drew back after earlier use. A modern economy unleashes creativity and vision yet manages with some success to harness it to the expertise of entrepreneurs, the judgment of financiers, and the gumption of end-users.11
The basics of the modern economy—how it functions as an innovation system—have been set out. Participants have new commercial ideas, which grow out of their deep engagement and long observation in their respective industries and professions. The process of development of new methods and products involves a variety of financial entities—angel investors, super-angel funds, venture capitalists, merchant banks, commercial banks, and hedge funds; it involves various sorts of producers—start-up companies, large corporations and their spin-offs; and a range of marketing activity—marketing strategy, advertising, and the rest. On the end-user side, there are company managers making pioneering assessments of novel methods and consumers deciding what new products to try out. Both are learning how to use the new methods and products they have adopted. By the mid-19th century, building blocks for a modern economy were in place in Britain and America, later in Germany and France:
There was a swarm of entrepreneurs enjoying rights to hold property and do business, rights against the state, and the protections of contract law. These entrepreneurs, in companies or proprietorships they founded, were heavily engaged in tinkering with new methods and dreaming up new products. Banks seldom lent or invested in entrepreneurs without a track record. Family and friends often acted as “angel investors” to get the entrepreneur’s project started. Many new businesses had to plow back earnings if they were to expand. In England there were country banks supplying entrepreneurs with short-term credit and trusted attorneys accepting deposits from clients and lending long-term to entrepreneurs. And sometimes individuals became partners in a venture or put up the fee to buy patent protection. A few banks virtually went into business, as the Fuggers had done in south Germany centuries before—some advising and investing in whole industries. In America, country banks tended to be more entrepreneurial. New England businesses not uncommonly went into banking, even selling bank stock to finance their business ventures. Other banks lent to family and friends. (Not many of these proto-venture capitalists could take equity stakes, as today’s venture firms do, until entrepreneurs created joint-stock companies that could issue shares.)12
The modern economy, seen as a vast, unceasing project to conceive, develop, and test ideas about what would work and what people would like, has had profound consequences for work and society. Its predecessor, the mercantile economy, offered little work and what there was offered a wage and little else. It may have been a relief from domesticity, yet it was tedious. In modern economies, work is nearly universal: economic inclusion is far wider than in mercantile times. This work is central to people’s experience, particularly their mental life, and shapes their development. Thus the modern economy institutes a way of life. The fierce struggles over economic systems, which came to a head in the 20th century, were all about the human experiences that came with the modern economy and the loss of what had gone before.
A Social System
Most innovative ideas envision adoption by others, not just by the conceiver or entrepreneur. And a multiplicity of entrepreneurial projects is going on at any one time. Most of the fuel for the modern system—and the worst complications—derives from its operating in a society, not on a one-person island. The multiplicity of the actors, each acting independently, adds enormously to uncertainty in the economists’ sense. Frank Knight, an influential American economist, contrasted the known risk when a known coin is flipped, such as one known to be fair, with the unknown risk when an unknown coin is flipped, which he called uncertainty. He saw that business was rife with this Knightian uncertainty. He seemed to appreciate that this uncertainty is a hallmark of the modern economy.13
Uncertainty about the end results of an entrepreneur’s project for a new product is in part the micro uncertainty about whether end-users will like the new product enough to buy it. The entrepreneur lives in fear that end-users will like it but will like some other entrepreneur’s new product more. (Crusoe had only to fear that he himself might not like his new product.) Furthermore, the results of other entrepreneurs’ ventures will affect the results of the entrepreneur’s own venture. (The micro uncertainty about whether those other products being readied will be liked raises uncertainty about whether output and income in the economy will hold up. And that creates a macro uncertainty about whether end-users of a new product will be able to afford to buy it.) Thus, as John Maynard Keynes was first to see, the uncoordinated nature of the modern economy’s entrepreneurial projects spawns a future unfolding in ways and magnitudes that are very indeterminate. The future, after any considerable length of time, becomes largely unknowable. About the future, Keynes wrote, “we simply do not know.” In the space of a generation, an economy can take a shape that would have been unimaginable for the previous generation.14
For both Keynes and Hayek it was bedrock that new ideas are drivers of economic history—contrary to the stark determinism of, say, Thomas Hobbes or Karl Marx—because they understood that new ideas are unforeseeable (if they were foreseeable, they would not be new) and, being unforeseeable, have an independent influence on history. Yet the unknowability of the future makes all the more uncertain the consequences of developing today’s ideas. Hence, any plausible projection of economic development in a modern economy is out of reach, just as Darwin’s theory of evolution cannot predict evolution’s course. Still, we learn some truths by studying processes for “growth in knowledge” and innovation: Failed ideas are not always valueless, since they may indicate where not to try any further. Successful ideas—the innovations—may inspire further innovations in an endless virtuous cycle. Originality is a renewable energy, driving the future in unknowable ways, creating new unknowns and new mistakes, thus new scope for originality. We will do well to study the fertile soil that high economic dynamism requires.
The modern system thrives on diversity within the society. How willing and able to innovate a society is—its propensity to innovate or, for short, its economic dynamism—obviously depends not only on the variety of situations, backgrounds, and personalities among potential conceivers of new ideas. (The entries into the music business of Jews in the 1920s and blacks in the 1960s are familiar examples.) A country’s dynamism also depends on the pluralism of views among financiers. The more opportunity that an idea has to be evaluated by someone who can appreciate it, the less likely it is for a good idea to be passed up for funding. (To let the king pick all the creative projects for financing would be a recipe for making a monochromatic country.) Dynamism depends, among many other things, on the variety of entrepreneurs from whom to pick the one most in tune or most prepared to embody the new idea in a workable method or product. Clearly the pluralism among end-users is also important. If they were all identical, finding an innovation they would all like would be like precision bombing.
If all this diversity is important, we have an answer to a question avoided earlier: Historically, the system of creativity and vision described above—thus, growth in knowledge and innovation—exploded in the private sector, not the public sector. Could a comparable system for growth in knowledge and innovation function inside the public sector? Not if diversity among financiers, managers, and consumers is quite important.15
The success of this system depends also on the degree of interactivity within it. A project to dream up a new product typically begins with the formation of a creative team. A project to develop a newly conceived product for commercial production or marketing typically begins with the formation of a company staffed by a number of people. Anyone with experience operating in a group understands that, generally speaking, groups are capable of producing a set of insights far beyond what the members would have been able to do working in isolation. The belief of some social critics that one can have a good career working at home neglects the value of being pinged by the ideas and questions of others—especially those we learn to admire and trust. And the belief that a company can place large numbers of its employees in solitary locations, such as their homes, without any cost to its innovation overlooks the importance of serendipitous interactions at the watercooler and luncheon meetings.
Interactions also enhance individual powers. When the principal horn player of Amsterdam’s Concertgebouw Orchestra was complimented on the high level he had reached, he replied that he never could have done it without interactions with the rest of the orchestra. A team—a well-functioning one, at any rate—achieves not just the productivity from combining their complementary talents, as a classical economist would say, but also, in management theorists’ terminology, the “superproductivity” that comes as every member of the group acquires a heightening of his or her talent, thanks to their mutual questioning and resulting gains in insight, and their urging one another on, a point emphasized by the management philosopher Esa Saarinen.
There is also interactivity over distance and time. The ideas of a society combine and multiply. A person’s fertility in producing new ideas is hugely increased by exposure to recent ideas generated by the economy in which the person functions and, these days, the global economy. If isolated, the person might have a run of failed ideas at some point and be unable to generate any more. In Robinson Crusoe the economist-novelist Daniel Defoe shows us how pitifully few ideas Crusoe has without a society from which to take inspiration. The contention that to maximize its prosperity, a country like Argentina must remain agrarian rather than become urban, in view of its natural advantage in producing sheep, overlooks the fact that rural life is not conducive to the intellectual stimulation and wide-ranging interchange that contributes so critically to creativity.16 Thus wide participation and the huge agglomeration in cities of people in diverse pursuits serve to amplify the creativity of the system.
This chapter has viewed the anatomy and functioning of modern economies—the historical ones of the 19th and 20th centuries. In its first decades, participants had little sense that elements for a new system were in place and were quickly developing. But with the growing awareness of the modern system in which they were operating, there was a gathering sense that the new system was opening up fantastic possibilities. The next two chapters tell the little-known story of the gains in productivity and living standards the system brought—the material benefits—and the gains in the character of work and the meaning of life itself.
1. This usage is not universal but is increasingly common. An example is Denning and Dunham, The Innovator’s Way (2010). To economists, ever since Schumpeter’s 1912 work, an innovation has meant a new practice, not just a new development. (For him, development and adoption went hand in hand, both being a sure thing.) Scientists tend to call the invention of a new method or product an innovation whether or not buyers are found for it.
2. The Austrian-born Fritz Machlup did some early work on measuring the importance of the industries aimed at producing new economic knowledge. The estimate above is not a precise calculation but is not just an impression either.
3. Do entrepreneurs generally receive large nonpecuniary returns? Schumpeter was skeptical. He writes poignantly of the successful entrepreneur who finds that admittance to polite society will not be one of the rewards. He also thought that the average realized pecuniary return of entrepreneurs was below normal: they were too sanguine or paid a steep price to have some fun. Now there appears to be a consensus that, even in the unromantic 20th century, modern entrepreneurs as a group find big nonpecuniary rewards—“the time of their lives,” as some put it; but perhaps at some cost to their cash flow. None of this matters for how the modern economy works, however.
4. See his 1942 monograph Capitalism, Socialism and Democracy. The brilliant 1912 book with which Schumpeter made his name portrayed his subject as an infallible machine, one that had no creativity but could promptly and faultlessly seize every opportunity for profitable investment soon after it arose. The 1942 book with which he closed his career went further in concluding that corporate managements could promptly and faultlessly seize opportunities for technological advances. That led to the question, if corporate managements could do it, why not state agencies and socialist enterprises? That may have deepened Schumpeter’s feeling at the end of his career that the Western world was on an inexorable “march into socialism.”
5. Hume’s great themes—the necessity of imagination for discovery or change, the importance and legitimacy of sentiment or “passions” in human decisions, and the danger of depending on past patterns to hold up in the future, all in his 1748 masterpiece An Enquiry Concerning Human Understanding—can be seen as prefiguring the modernity to come, in which imagination would run wild, the growth of knowledge would be rampant, and the future would be barely recognizable.
6. Various observers have written on the subject. In Somerset Maugham’s 1929 story, “The Man Who Made His Mark,” a man fresh out of a job, noticing that the neighborhood has no tobacconist, has the drive to restart his life by opening a tobacco shop there. End-users, too, must share in the dynamism of Maugham’s tobacconist. What became known as the Nelson-Phelps model of the adoption of an innovation, published in 1966, was an early attempt to highlight end-users in the innovation process, such as farmers risking adoption of new seeds and fertilizers. The focus there was on the importance of end-users’ education. Amar Bhidé in his 2008 book focused on the need for “venturesome” end-users.
7. This work begins with Hayek’s 1937 presidential address to the London Economic Club, “Economics and Knowledge,” and ends with his much-cited 1945 paper “The Use of Knowledge in Society,” which has the notion of “changing circumstances.” These and other papers collected in his Individualism and Economic Order (1948) were conceived in the period from the 1920s until almost the 1950s, when socialism and corporatism were hotly debated by many European economists. The present chapter, though, is focused on how Hayek’s views contributed to the understanding of modern capitalism. Chapter 5 takes up the debate over socialism and Chapter 6 the modern economy’s struggle with corporatism.
8. Vincenti, “The Retractable Airplane Landing Gear” (1994, pp. 21–22).
9. Hayek’s 1961 piece is “The Non Sequitur of the ‘Dependence Effect’%” (reprinted in 1962). The later paper mentioned is the 1968 “Competition as a Discovery Procedure” (published in English in 1978). A 1946 paper contains the first hint of this new chapter in Hayek’s thought.
10. The notion of “changing beliefs” figures in Hayek’s The Counter-Revolution of Science (1952). To really understand a social phenomenon, he writes, one needs to know “what the people dealing with it think” (p. 156).
11. It is not controversial to say that the economies that have stood out for their extensive and effective use of creativity and judgment are those making heavy use of a relatively well-functioning “free enterprise,” or “capitalist” system—whatever the social and political systems they operate with. They have been the great historical examples of modern economies—leaving aside the issue of whether they are the sole examples. Yet well-functioning capitalism could perhaps be superseded by some new form of the modern economy.
12. After nearly two centuries in which most knowledge of how the system worked was lost, a new literature has sprouted up, much of it spearheaded by Cambridge University Press. Chapter 4 on the historical origins of the modern economy conveys some of that. In the above paragraph, the pieces of the financial puzzle were put together by the late Jonathan Krueger, a student of mine at Columbia in 2010.
13. Knight’s radical book, Risk, Uncertainty and Profit, was published in Boston in 1921, delayed for several years by World War I. (Another brilliant though less influential book on uncertainty, Keynes’s A Treatise on Probability (1921), suffered the same delay.) An idiosyncratic thinker, Knight was fascinated with the proposition that if there were no uncertainty, there would be no genuine profit earned by businesses, only a normal return that could be thought of as required to pay the competitive level of interest to creditors.
14. See Keynes’s General Theory (1936), with its allusion to Plato’s “animal spirits.” (Hayek’s 1968 paper on the discovery procedure could have made similar points but it steered clear of them.) Ideas were never far from Keynes’s mind, it seems. His greatest line was, “the world is ruled by ideas and little else.” It was stated in his discussion of the hold that prevailing policy ideas have over nations. But Keynes’s own career demonstrated that new policy ideas sometimes break in. Similarly, the ideas in business and finance, both old and new, dominate the directions and the swings in the business world.
15. Whether the presence of a really large public sector, marked by massive state purchases of goods and services for defense, the environment, and so forth that add up to half the GDP greatly impairs the economy’s creativity and judgment, thus seriously reducing innovation and growth in knowledge, is another question. It is best deferred to the last two parts of this book.
16. In a 1940s debate, the Argentine economist Raúl Prebisch advocated taxes on agricultural output and import duties on manufactures. He was opposed by the Chicago economist Jacob Viner, a classical advocate of free trade and laissez-faire. Both Prebisch and Viner were too classical to articulate the gain in innovativeness that could be expected from urbanization. In their shared perspective, there was no such thing as creativity, engagement, and personal growth in a modern economy—there were only resources, technologies, and tastes, and the consumption and leisure they enabled.