Business Cycle Theory Explained by Joseph Schumpeter

The leading economic theoretician to work on trade cycles in the first half of the twentieth century was undoubtedly Joseph Schumpeter. He was an Austrian, but cannot properly be regarded as a member of the Austrian School. He is not a liberal economist like von Hayek or von Mises. Joseph Schumpeter can properly be regarded as a man of the left, though certainly not of the far left. In 1927, Schumpeter published in Economica his paper on” The explanation of the business cycle”. After the global shock of the banking crisis of 2008, which itself came more than eighty years after this paper was published, the world is again looking for explanations.

Schumpeter is important because he developed a theory of business cycles which puts its emphasis on industrial innovations rather than banking. Most business cycle theories put their emphasis the other way, and are essentially monetary. Maynard Keynes is just as much a monetary economist as Milton Friedman when he comes to his explanation of business cycles. This is surely an argument which is going to be reopened.

Schumpeter starts his account of business cycles at the top rather than the bottom of the cycle. “These booms consist in the carrying out of innovations in the industrial and commercial organisms. By innovations I understand such changes in the combinations of the factors of production as cannot be effected by infinitesimal steps or variations on the margin. They consist primarily in changes of methods of production and transportation, or in changes of industrial organisation, or in the production of a new article, or in the opening up of new markets or of new sources of material. The recurring periods of prosperity of the cyclical movements are the form progress takes in a capitalist society.”

He goes on to argue from economic history – and this part of the Schumpeter argument would be difficult to question. “The reader needs only to make the experiment. If he comes to survey industrial history from, say, 1760 onwards, he will discover two things; he will find that very many booms are unmistakably characterised by revolutionary changes in some branch of industry which, in consequence, leads the boom, railways, for instance in the forties, or steel in the eighties, or electricity in the nineties…”

His conclusion is stated very clearly: “booms and consequently depressions are not the work of banks: their cause is a non-monetary one and entrepreneurs demand is the initialing cause even of so much of the cycle as can be said to be added by the act of banks.”

In 2008, we have had a conspicuous example of a crash apparently caused by the banks. It looks like the “debt-deflation” type of crash. But we also have to account for oil, for Google, for China. These are the triggers which may be the underlying explanation of the behaviour of the banks. The relationship between business cycles and changes in business conditions may be mediated through bankers or speculators, but the big causes, as Schumpeter believed, may not lie in the banks themselves.

William Rees-Mogg
for Markets and Money

Leading political editor William Rees-Mogg is former editor-in-chief for The Times and a member of the House of Lords. He has been credited with accurately forecasting glasnost and the fall of the Berlin Wall – as well as the 1987 crash. His political commentary appears in The Times every Monday. His financial insights can only be found in the Fleet Street Letter, the UK's longest-running investment newsletter.

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