How would Schumpeter view this crisis?

This is an interesting lecture by Barry Eichengreen which he gives at Schumpeter society. Eichengreen says how would Schumpeter view this crisis:

 No doubt he would have been of the view that the crisis was rooted in earlier excesses. He appreciated the limits to rational decision making and the tendency to engage in herd behavior, and therefore the propensity for markets to boom and bust. He understood  these tendencies in terms similar to those of present-day economists specializing in behavioral economics and the economics of information.

 He understood how easy credit can combine with new technologies to produce an unsustainable boom followed by a disruptive crash: his favorite examples (from the history of my country) were the railway boom of the 19 th century and the haphazard growth of the motor vehicle industry in the 20 th . The boom financed by easy credit had the benefit of allowing more extensive experimentation with the commercialization of these new technologies than would have occurred in its absence. The bust then weeded out the failed projects and unsuccessful entrepreneurs. These dynamics were intrinsic to the operation of the capitalist system..

In other words, Schumpeter was something of a liquidationist. Not to the extent of Treasury Secretary Andrew Mellon, who famously defended the cleansing effect of the Depression by urging President Hoover to .Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate..purge the rottenness out of the system.. But he did see downturns as correcting earlier mistakes and thus as having a cleansing function.

But he also saw the need for government intervention to prevent the process from  leading to the breakdown of the economic and financial system. The 1929-32 downturn in the United States, he insisted, remained an unexceptional recession with mainly constructive, cleansing effects until it was allowed to infect the banking system and spawn a full-blown financial crisis.

So did he support Keynes? Absolutely not, he and Keynes were big time rivals. He would have disagreed to all tjhe govt spending without fixing the finance system.

That said, he was skeptical about Keynesian policies. He was, of course, a skeptic of all things Keynesian, given his self-conscious competition with Keynes for the mantle of greatest economist of the 20th century. Were he alive today, I suspect that Schumpeter would argue that we made the wrong choice in the last couple of years by relying so heavily on Keynesian pump priming while not doing enough to fix our broken banking systems, through recapitalization and, where necessary, temporary nationalization.

A sound and stable financial system that can efficiently allocate investible funds and not just a certain level of aggregate spending, he would have argued, is required for economic stability and, importantly, for the innovation that incubates technological progress. Propping up demand while leaving the banks weak will make for a credit-less, innovation-poor recovery. Moreover, propping up demand will allow the banks to stagger on . this of course having been the express purpose of policy in the United States . in turn allowing many of the same bank CEOs who played a role in fomenting the crisis to remain in place. So much for the cleansing effect of the downturn.

Though Eichengreen does not agree to this supposed Schumpeter idea as costs of such high unemployment are very high and it needs a fiscal stimulus.

Then Eichengreen also discusses whether financial innovation is useful? He says like in the pharma industry we have regulation which tests products before launch we need same for financial products. So a Consumer Financial Products Safety Commission is an important idea. He also discusses how Schumpeter would have analysed the regulatory failure in this crisis. The young Schumpeter was a maths guy who saw economics as exact economics which can be modeled etc. So he could have been ok with all the fancy risk management techniques like VAR etc. Older Schumpeter was more sociological. He would have also emphasized the role of ideology in shaping regulation.

Schumpeter would no doubt have also emphasized the role of ideology in shaping views of regulation. Looking back, one cannot help but be impressed by the role of  deregulationist deology, especially in the U.S. and UK in the wake of Reagan and Thatcher, in setting the stage for the subsequent crisis. The idea that markets, left to their own devices, get it right and that governments, when they intervene, can only get it wrong became deeply ingrained in intellectual and policy discourse. The idea that we should move in the direction of light-touch regulation of financial markets and institutions, where banks are relied on to manage their risks using their own internal models (along with the ratings they purchase on the securities they issue) reflected this ideology. So did policies under the Bush Administration to starve the regulators of the financial and human resources needed to do their jobs. That we may now be turning back in the other direction reminds us that crises can weaken even deeply ingrained ideological presumptions, but at what price?

And finally, what would Schumpeter’s solution be?

In Science and Ideology he recommended an economics better informed by the analysis  of actual historical events and processes, as opposed to the building of time- and place-invariant mathematical models. It was not that economic historians are less subject to ideological biases . after all, we have social origins too . but that we are more aware of the existence of such biases because we are in the business of analyzing social origins and their consequences.

While the crisis has been bad for the reputation of mainstream macroeconomics, it has been a good crisis for economic history. The case for economic history as now conventionally made is that financial market participants and policy makers should study history so that they are able to look beyond recent events. A knowledge of history will serve as a caution that when an asset class is booming that boom will last forever. History will remind them that what goes up can come down. This is history as a corrective to the “this time is different” fallacy.

I would argue the role of history is more than just this. It reminds us that modeling choices are not independent of the social milieu of the modeler. And it is a reminder that  social processes, including economic and financial processes, are complex and nonlinear in ways that can render counterproductive and dangerous efforts to reduce them to simple formulae that float in their own mathematical ether, suspended above social and political processes. It reminds us that it can be equally counterproductive and dangerous to make policy on that basis.

. nearly a defunct economistGreat stuff. Knowing about both Eichengreen and Schumpter’s views in one place. Knowing more about

One Response to “How would Schumpeter view this crisis?”

  1. Akshaya Kumar Jena Says:

    Schumpeterian diagnosis of capitalist economy might be correct, but of no use since he did not prescribe the medicine to remedy the malady. Keynesian prescription with its efficacy more often than not does not really warrant any misgiving on the pathological quality of the great master John Maynard Keynes.

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