Innovation and Entrepreneurship - The Austrian Economist Joseph A. Schumpeter

By Sigurd Pacher

"Surely, nothing can be more plain or even more trite common sense than the proposition that innovation [...] is at the center of practically all the phenomena, difficulties, and problems of economic life in capitalist society." So wrote the economist Joseph Schumpeter, who is often called the "father of entrepreneurship" or the "father of creative destruction," about innovation as outlined in his book "Business Cycles: Theoretical, Historical, and Statistical Analysis of the Capitalist Process" which was first published in 1939. Innovation held a key role in Schumpeter's thinking which, again in his own words, "is the outstanding fact in the economic history of capitalist society."

Some contend that the ideas of innovation and entrepreneurship are most likely Schumpeter's most distinctive contributions to economics. Joseph Alois Schumpeter was born on February 8, 1883, in Třešť, Moravia (then part of the Austrian-Hungarian Empire), a small town of 4,500 people, about 100 miles north of Vienna. His father died in a hunting accident when Schumpeter was four, and at the age of ten he moved with his mother, who had remarried to a high-ranking army officer to the imperial capital city of Vienna. He went to an elite high school before studying at the University of Vienna, from which he graduated with a doctoral degree in law in 1906.

Just five years later, after having finished his book on "The Nature and Essence of Theoretical Economics," he became professor of economics and government at the University of Chernivtsi (German: Czernowitz) in the Austrian crown land of Bukovina. (Bukovina, the most eastern province of the Habsburg Monarchy, today is part of Ukraine and Romania.) In 1911, Schumpeter became a tenured professor of political economy at the University of Graz, Austria. Shortly before the outbreak of WWI, in 1913/14, he was a visiting professor at Columbia University in New York. There, he met many highly regarded scholars such as Frank Taussig and Irving Fisher and also received an honorary doctoral degree.

In the aftermath of WWI and the break-up of the Austrian-Hungarian Empire, Schumpeter, at the age of 36, became Minister of Finance of the newly founded Republic of German-Austria in mid- March of 1919. (Under the provisions of the peace treaty of Saint Germain, signed on September 10, 1919, German-Austria had to change its name to Austria.) In sharp contrast to most of his compatriots, Schumpeter believed that the new Austria could survive economically without joining Germany. To restore Austria's public finances and to maintain Vienna's role as the financial center of Central Europe, he advocated for a capital levy.

Yet, after only seven months in office, having antagonized every other member of the cabinet, he had to resign from his post. Shortly thereafter, in 1921, he became the president of the private Biedermann Bank and amassed a fortune. When a severe economic crisis hit Austria in 1924, the bank collapsed and Schumpeter ended up bankrupt and was left with a mountain of debt. From 1925 to 1932, he held a chair in public finance at the University of Bonn, Germany. He then permanently moved to the United States (he became a U.S. citizen in 1939, a year after Austria had been annexed by Germany) where he taught and worked at Harvard University until his death on January 8, 1950, at the age of 66.

Schumpeter was married three times: First to Gladys Seaver, an Englishwoman, whom he later divorced, then to Anna Reisinger, an Austrian, who died in childbirth in 1926, and eventually to Elizabeth Boody, an American and fellow economist, who passed away in 1953. Schumpeter was a prolific writer. His theories and analyses have been published in more than fifteen books and pamphlets, over 200 articles, book reviews, and review articles. "Theory of Economic Development," which first appeared in 1911, is often thought to be his most original and most lasting book. He himself considered it to be his seminal work. It established his main theme on capitalism which postulates that its destructiveness is inseparable from its creativity.

Capitalism is a dynamic process of wealth creation and change, driven by innovation, not routine. Despite all its ups and downs, capitalism benefits not only the rich but all strata of society. In this book, Schumpeter also laid out the crucial role that entrepreneurs play in breaking up old structures and creating new ones. In his 1939 book "Business Cycles," he defines, "For actions which consist in carrying out innovations, we reserve the term Enterprise; the individuals who carry them out we call Entrepreneurs." Entrepreneurs, in his view, are the only ones who bring about long-term economic growth. They are not the "risk bearers," but the ones who continuously seek an innovative edge. Innovation drives progress and is itself driven by competition. It throws out the old and brings in the new. It unsettles the established order and brings with it turmoil.

"Times of innovation [...] are times of effort and sacrifice, of work for the future, while the harvest comes after," Schumpeter further observes in "Business Cycles." As entrepreneurs seek high profits, they hope to bring to the market new goods which enjoy, at least for some time, a non-competitive advantage. Thus, it appears that innovation is best carried out by (temporary) monopolies. (This also seems to be one reason why Schumpeter viewed big business in rather friendly terms.) In the long run, however, large firms – both the source and the result of successful innovation – start to dominate economic life. Over time, they become more bureaucratic and tend to constrain innovation which morphs into a matter of routine.

In the end, as Schumpeter elaborates in his book "Capitalism, Socialism, and Democracy," originally published in 1942, automation and depersonalization takes root, capitalist motivation comes to a halt, and discontent rises. Intellectuals (and, contrary to Marx, not the proletariat) become the voices of disenchantment and capitalism perishes. Or, as Schumpeter put it reluctantly, "Can Capitalism survive? No. I do not think it can." Schumpeter's forecast that, due to its very success capitalism is doomed to death, has not come true by now. In fact, a quarter of a century after the fall of the Iron Curtain, capitalism has become the dominant economic force around the globe.

Even in one-party-states like China the economy is based firmly on capitalist principles. Yet, some might argue that the sub-prime banking crisis in the U.S. and the sovereign debt crisis in Europe that shook the global economy not long ago has given ample proof of the rather rocky times capitalism currently encounters. Further, five years after the end of the "Great Recession" in the U.S., the U.S. unemployment rate is still above average, thousands of homes are still "underwater," and the median household's net worth (in real terms) is below the level reached in the late 1990s. Some European nations continue to face significant economic problems, and the economic growth rates of major emerging countries seem to be slowing.

In contrast, the number of university graduates continues to rise. While in 1995, the OECD average of first-time college graduation rates was about 20%, this number has now almost doubled to roughly 40%. With capitalism in turmoil and the number of intellectuals rising, do we witness the beginning of the end of capitalism as Schumpeter feared? Even if Schumpeter has erred (so far) in predicting the end of capitalism, his ideas of innovation and entrepreneurship as the driving force behind economic growth are still valid. In his analysis, he distinguished inventions from innovations and pointed out that innovations go well beyond inventions as innovation also includes new ways of production, new products, and new forms of organization.

While inventions lay the groundwork, it needs entrepreneurs to bring them to the level of innovation and thus to the level of production and marketability. Innovation causes old technologies, skills, and equipment to become obsolete while, during the course of this process of change, it creates new ones and ensures progress and growth. Perfect competition, in contrast, is seen as less important as, by itself, it does not contribute to newness. The traditional or classical factors of production (inputs) of land, labor, and capital are also not sufficient to explain the output; it needs entrepreneurial activity.

Schumpeter’s focus was not on arriving at a (static) equilibrium, but on elaborating on the dynamic disequilibrium that is essential for capitalist markets and as such for a healthy economy. He insisted that – without innovation – there was no economic development and no wealth creation. Schumpeter had his doubts about the free market, and he was not an absolute non-interventionist like his fellow Austrians Ludwig (von) Mises and Friedrich (von) Hayek, both members of the Austrian School of Economics, but he disagreed with the systematic stabilization policy advocated by John Maynard Keynes for fear it would minimize the crucial disorder and bring progress to an untimely and premature end.

In fact, during his lifetime, Schumpeter was always overshadowed by Keynes, his contemporary (he shared with him the same birth year) and intellectual rival, who had risen to widespread eminence after the publication of his “General Theory” in 1936. There seems to be hardly any doubt that Schumpeter felt that, as his work initially received rather little acclaim, he never became (at least in the public eye and mind) the great economist that he had always aspired to be. Failure, disaster, and disappointment were key elements of Schumpeter’s later adult life. He sought glamour, but never became as renowned as Keynes. He did not create a new theory or school named after him.

He failed as both finance minister and bank president. Allegedly, he was not a good teacher either; to some of his students, he seemed unorganized and unsystematic. And late in life, he battled depression and despair. Yet, despite all those troubles and difficulties, he is said to have generally managed to display a semblance of good cheer and confidence. He had a fine sense of humor, he could be charming, and he is also said to always have behaved in public like a Continental European bon vivant. But he was also a “loner,” a controversial figure and for some an unprincipled opportunist. It seems that the time at the elite school in Vienna, during the last years of the waning Habsburg Empire, had a huge impact in shaping his character.

In no time, he imitated and mastered the manners and behaviors of his aristocratic classmates which might explain why a friend of his later remarked that he “never seemed to take anything in life seriously.” He was considered arrogant, egocentric, and cynical. He was brilliant, but also obsessive. Some called him a dandy, a snob, or a showman. For sure, Schumpeter had his part in contributing to this assessment. As the story goes, he fondly used to remark that he had had three ambitions in life: to be the world’s greatest economist, Austria’s greatest horseman, and the best lover in Vienna. In one of them, he added, he had failed, but he never elaborated any further. According to a different source, he admitted to failure only with the horses.

In any case, coming from a middle-class background, but filled with tremendous ambition, he was a man who sought glory and liked to behave like an aristocrat. With an ego as big as his, he had to be both wrong and right. No surprise the Austrian novelist Karl Kraus, internationally well-known for his masterpiece “The Last Days of Mankind,” blamed Schumpeter for a lack of convictions and once noted satirically that he had “more different views than were [even] necessary for his advancement.” And John Kenneth Galbraith remembered, “Given the choice between being right and being memorable, Schumpeter never hesitated.” In retrospect, there is no doubt that Schumpeter, a man of many interests and talents, was one of the foremost thinkers of the 20th century.

During his years at Harvard University, he taught many students who later rose to prominence. Among them, just to name a few, were Paul Samuelson, who not only served as an adviser to two U.S. Presidents, but also, in 1970, was one of the first to receive the newly created Nobel Memorial Prize in Economic Sciences, and James Tobin, who, in his lifetime, served on the Council of Economic Advisors and the Board of Governors of the Federal Reserve System. In his works, Schumpeter not just focused on economics, but also explored interrelations between sociology, history, law, literature, and psychology. He liked to surprise others, he enjoyed paradoxes, and he loved to toy with ideas. Unsurprisingly, his work shows some tensions and inconsistencies.

Yet, he was a true intellectual, who unquestionably took pleasure in pursuing intellectual debates and winning intellectual battles. Like his entrepreneurial theory which is hard to fit into formal mathematical models, so is he difficult to classify under any particular school of thought. In fact, he feared becoming the orthodoxy himself. Still, his ideas on innovation and entrepreneurship which placed technological change at the core of economics have fascinated the human mind for decades and will undoubtedly continue to do so in the future. Or, to quote Forbes magazine which wrote in 1983, on the occasion of the centenary of Schumpeter’s birth, “Schumpeter […] had wisdom. [And] wisdom endures.”