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

Claim your FREE Special Investor Report…

Why Interest Rates Could Stay Low for the 21st Century… and How YOU Can Profit
Markets & Money Free ReportWill Australian interest rates hit 0% in the next couple of years? If controversial economist Phillip J Anderson is correct… super–low interest rates could be here for the next century. In this special investor report you’ll learn how you can take advantage of low interest rates and potentially make a fortune over the coming decades.

Download this free report now and discover:

  • How to Boost Your Wealth Four Ways in a Low Interest Rate World: Inflation is your biggest enemy when interest rates are low. Phil reveals his four–pronged strategy to overcome this… and shows you where to profitably park your cash in the coming decades.
  • How the ‘Victorian Equilibrium’ Can Make You Rich: What if you could accurately predict where interest rates will travel in the future? You’d know the best time to lock–in rates on your mortgage repayments and save bucket loads of cash… or pick up the interest rate sensitive stocks most likely to rocket higher. As Phil reveals, if you understand the centuries old ‘Victorian Equilibrium’ discovered by an American history professor… you’ve got the next best thing to a crystal ball for interest rates.
  • Why this $402 Million Decision Signals Low Interest Rates: In October 2014, UK treasurer George Osborne announced Britain will pay back debt used to finance the First World War — 96 years after the first shot fired. Phil reveals what this landmark decision means for long term interest rates both in Australia and across the globe and how this could affect your long term investing habits.

To download your free report ‘Why Interest Rates Could Stay Low for the 21st Century’ simply subscribe to Markets and Money for FREE today. Enter your email in the box below and click ‘Send My Free Report’.

We will collect and handle your personal information in accordance with our Privacy Policy.

You can cancel your subscription at any time.

Leave a Reply

4 Comments on "Business Cycle Theory Explained by Joseph Schumpeter"

Notify of
Sort by:   newest | oldest | most voted

Innovation explains booms, but not busts. Say the world comes out with a new technology that increases productivity. At first, as business implement this technology, there is a significant increase in economic growth. Eventually, as the technology becomes saturated, growth slows back down to normal levels. However, there is no explanation as to why this process would lead to negative growth.

Well, first we have to realise that the boom cycle is very long, eg the last one in US lasted from 1982 to 1999 ,, In such a boom cycle everything works – monetary policy works, intervention works , complex financial products work — simply because the whole economy is undergoing a sea-change … there are localized interruptions lasting for maybe one to two years at max (eg 1991) , but Fed intervenes and is apparently able to correct the problem ignoring the fact that we are in midst of an innovation boom ,, but after the so called schumpeterian… Read more »
At what point in Schumpeter time does Newmark’s original heresy become network orthodoxy in the bureaucrats boardroom? » Out With A Bang

To John,

Schumpeter’s idea of “Creative destruction” will answer your question.

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to