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Do Innovations Cause Business Cycles?

Mises Daily: Thursday, January 07, 2010 by

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Agora — "market" — was the name for the public place in the center of ancient Hellenic cities. Spanish film director Alejandro Amenábar recently gave his new movie the same dignified title. It tells the story of Hypatia of Alexandria, a wise and proud woman, a teacher of philosophy and astronomy at the library of that old metropolis. During those times, the dominant model of the solar system was the Ptolemaic view, in which the earth is located in the centre, and the sun and all the planets surround it in circles.

Since the circle was considered to be the most perfect shape, it was conjectured that the gods designed the movement of the celestial bodies in that scheme. However, the observed movements of the objects of the sky did not coincide with the predictions of the simple geocentric model. The idea of Ptolemy, then, was to introduce smaller secondary circles, called epicycles, whose centers were rotating around earth on a bigger circle.

The patterns described by this theory seemed to match reality.

But, as we know today, this was all wrong. In the movie, Hypatia offers her alternative, heliocentric model. If one considers the relatively poor tools available for astronomical research in those days, Ptolemy's fallacy is excusable. But modern economic science is not free from this kind of error either. In this article, I would like to give an example of an economic theory that reminds me of the case presented above.

Innovations and Business Cycles

A widely held theory holds that innovative activities cause the ups and downs of the business cycle. Although this view is not so much defended in mainstream economics,[1] you can often hear this argument in private conversations and — even more important — in political advice.

The most prominent defender of that view was probably Joseph Alois Schumpeter.[2] He stated that booms are due to technological or other innovations whose implementations at first seem to promise high profits. After a while, more and more entrepreneurs copy the strategy of the pioneer firms until competitive behavior forces profits to go down again and a depression begins, in which the market is cleaned of unprofitable firms. This is a brief description of the well-known process of "creative destruction" — a term made famous by Schumpeter himself.[3] The now-achieved state of equilibrium is only maintained until a new innovation creates the foundation for another boom.

Economic history is sometimes interpreted in the same manner: the industrial revolution, the appearance of railway tracks, or the rise of cheap automobiles are examples. Furthermore, the dotcom bubble at the end of the last decade could have been due to innovations like the internet. Even the current crisis can be regarded as the result of financial innovations.

At first glance, the Schumpeterian approach seems quite plausible. Advocates of a free market might be especially attracted by this theory, because it emphasizes the enormous innovative powers of capitalism and provides overall a very positive view of the destructive dynamics of crisis. Its motto is that as dawn follows dusk, there will eventually appear new innovations that trigger the next boom — thus, there is no point in worrying about depressions. They are simply believed to be inherent in the fantastic "free-market innovation machine"[4] and therefore cannot be avoided.

But what then, in the situation of a depression, keeps the government from boosting the implementation of innovations by fiscal or monetary stimulus? We will deal with this important question in a brief moment, but first it suffices to explain why Schumpeter, as appealing as his view may be, committed the same error as did Ptolemy with his planetary model.

While formulating his theory, Schumpeter had to deal with a big problem: he tried to explain economic development and, at the same time, tried to keep the static theory of general equilibrium. The latter was largely developed by Leon Walras, who Schumpeter admired greatly, even calling him "the greatest of all economists."[5]

In Walras's model, however, there is by definition no change taking place. In order to explain empirical patterns, such as business cycles and economic development, Schumpeter then had to rely on another variable: technology or — in a broader sense — innovation. Since he still wanted to show the correctness of the equilibrium theory, he had to assume that innovations occur in clusters, i.e., discontinuously. For if this was not the case, there could never be any state of equilibrium in the economy.

That assumption however seems arbitrary. For entrepreneurial creativity, as well as new ideas in general, does not usually obey the metronome. Schumpeter could not abandon the idea of general equilibrium when he wanted to introduce dynamics into economic theory.[6] Thus, he was trapped in the "Walrasian box," as Rothbard puts it.[7] Just like Ptolemy before him, Schumpeter eventually introduced additional overlapping cycles into his worldview.

The patterns described by this theory seemed to match reality.

Do Savings Matter?

However, Nikolai Dmitrijewitsch Kondratieff, the discoverer of one of these Schumpeterian cycles, himself discarded technological changes as a cause for the ups and downs of the "long wave" he had observed in historical data.[8] He argued that the causality worked in just the opposite direction: it is not technological innovation that generates the boom, but the general boom that makes it possible for more and more firms to implement their innovative ideas. Without appropriate economic conditions, these ideas could not be implemented. Hence, innovative activity follows the course of the cycle — not the other way round.

Although Kondratieff has surely not thought of the Austrian Business Cycle Theory, his reservations toward the Schumpeterian explanation of business cycles nonetheless gives us a hint in the direction of an alternative explanation. In every moment there exist many ideas for possible innovations and improvements. Furthermore, the latest innovation has not yet been implemented in every business. Assuming that there always exist a lot of ideas whose only problem is to get enough funds, we find that it is not technology, but savings that limits development. A new innovation is only fully exhausted when every company has implemented it.[9] In order to do this they need capital. Society has to save first and then grant credit.[10]

Recognizing that a lack of savings is the real barrier for development, our attention is lead from Schumpeter's approach to the Austrian Business Cycle Theory. As Mises and Hayek showed again and again, a boom driven by credit expansion with fiat money leads inevitably to malinvestments. But Schumpeter, enclosed in the static and absurd model of general equilibrium, where no profits are achievable, endorsed credit expansion by the banks as a means to foster innovation.

There is, of course, nothing wrong with relying on credit in order to provide for the application of an innovative project. The problem only appears when these credits are created out of thin air, thus inducing malinvestments.[11] It is easily imaginable that in an environment of monetary expansion, many innovative projects are fostered that are in fact not sustainable.

The clusters of innovative activities that Schumpeter considered the cause of inevitable depressions are thus in fact a symptom of the distortion of the market process that is introduced by fractional-reserve banks. The words Hayek used to describe such a situation fit well into the period of the dotcom and subprime bubbles:

Now the chief effect of inflation which makes it at first generally welcome to business is precisely that prices of products turn out to be higher in general than foreseen. It is this which produces the general state of euphoria, a false sense of wellbeing, in which everybody seems to prosper.[12]

Schumpeter is right, though, that one of the major characteristics of entrepreneurship and capitalism is the innovative capacity. Yet that is not what triggers the cycle. Another factor needs to be present. Theoretical research on the nature of entrepreneurship, e.g., by Baumol[13] and others, has pointed out that the search for profit is not necessarily always constructive but can even be destructive.

Such is the case when "bad" institutions guide entrepreneurial activities into areas where they create, not mutually beneficial situations, but zero-sum (or even negative-sum) games. An obvious example is the democratically legitimized redistribution of wealth, which opens the door for all kinds of rent-seeking projects.

Another example is the destructive effect that fractional-reserve banking has on entrepreneurial activities. Fractional-reserve banking violates property rights and misleads the normal innovative activities of entrepreneurs by providing incorrect price signals. As a result, innovative actions are channeled to unsustainable projects, which eventually have to be abandoned. Hence, it is not the creative and innovative character of entrepreneurs as such but the misguiding effects of fractional-reserve banking that ultimately cause ever-repeating business cycles.

The "Green New Deal" as the Innovational Revolution of Our Time

The critical remarks mentioned above are of utmost importance for policy advisers. If the business cycle is not driven by innovations as such, but by fiat credit expansion, then using political means to push forward new innovations like "renewable energy sources" will not suffice to get the economy out of the slump.

From an economic point of view it is highly dangerous for the aid for such innovations to be flanked by expansive monetary policy. A recent study indeed suggests that this was already the case in Spain where a "green" bubble went boom and bust — with all its destructive side effects.[14] President Obama, and all the other politicians that recently got home from Copenhagen, would be well advised not to follow the Spanish example.

Conclusion

Innovation is without any question a major cause of economic development. But the claim that the innovative capacity of modern capitalistic societies sows the seed of general crises can be refuted, for such cyclical patterns only unfold if new innovations are financed by an expansion of fiduciary money instead of by voluntary savings.

Finally, we can detect another similarity between the Austrian analysis and Hypatia's critique of the Ptolemaic worldview: both were not welcome in their times. The wise woman suffered when she refused to recant her critical remarks. Today, times have changed and the struggle for the best theory is fought not by sword and fire but by pen and paper. However, the Austrian attempt to explain current affairs is still marginalized in professional and public debates. We ought to consider the cautionary words of the once-proud philosopher Hypatia: "Should not reason alone be the judge?"

Notes

[1] Overall, Keynesian and monetarist approaches seem to be preferred; although the Real Business Cycle Theory incorporates technological change as an example of an external "shock."

[2] Schumpeter, J. A. (1961): The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, New York.

[3] Schumpeter, J.A (1976): Capitalism, Socialism, and Democracy, New, York: Harper & Row, pp. 81–86.

[4] This expression is borrowed from Baumol, W.J. (2002): The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism, New York: Princeton University Press.

[5] "So far as pure theory is concerned, Walras is in my opinion the greatest of all economists. His system of economic equilibrium … is the only work by an economist that will stand comparison with the achievements of theoretical physics … [it] still stands at the back of much of the best theoretical work of our time." (Schumpeter, J. A. (1954): History of Economic Analysis, London: George Allen & Unwin, pp. 827–28)

[6] Schumpeter at least intended to stress the dynamic nature of capitalism and he had the desire to introduce this view into economic science. He stated, "The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process.… Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary." Schumpeter, J.A. (1976): Capitalism, Socialism, and Democracy, New, York: Harper & Row, p. 82. Schumpeter was thus well aware of the dynamic nature of economic science, but he said that the analytical tools of his time were only able to describe static aspects of it. (Schumpeter, J. A. (1908): Das Wesen und der Hauptinhalt der Nationalökonomie, Leipzig, pp. xix–xx)

[7] Rothbard, M. N. (1987): "Breaking Out of the Walrasian Box. The Cases of Schumpeter and Hansen," Review of Austrian Economics 1: 97–108.

[8] Kondratieff, N.D. (1926): Die langen Wellen der Konjunktur, Archiv für Sozialwissenschaft und Sozialpolitik 56, pp. 593–94.

[9] However, recent Austrian approaches to growth and welfare economics as well as the dynamic theory of efficiency suggest that such a situation will never occur. For what really causes progress is not the optimal allocation under the constraints of given resources and technology, but rather the entrepreneurial search for ever more innovative production processes, differentiation of products, and increase of production quality. These factors give a firm a competitive advantage over other members of the same industry and hence allow them to charge higher prices than marginal costs. A state in which a given innovation is fully exhausted is therefore not only unrealistic, it is even unprofitable for real firms in a competitive market economy. Profit incentives will most likely insure that such an equilibrated situation does not last. See Holcombe, R. G. (2009): "Product Differentiation and Economic Process," Quarterly Journal of Austrian Economics 12 (1): 17–35; on the theory of dynamic efficiency, see Huerta de Soto, Jesús (2009): The Theory of Dynamic Efficiency, London: Routledge.

[10] For a discussion on the relationship of technology and savings see: Skousen, Mark (2007): The Structure of Production, New York: New York University Press, pp. 215–64.

[11] Malinvestments are induced because early stages of production, such as R&D activities, are now fostered without an equivalent decrease in the demand for immediate consumption. Scarce factors of production are thus missing in the middle and late stages. The competition for these factors will eventually cause their prices to rise. Finally, it becomes clear that many investments in these early stages were actually not profitable at all. For an explanation of the microeconomic effects, see Huerta de Soto, Jesús (2006): Money, Bank Credit, and Economic Cycles, Auburn: Ludwig von Mises Institute, pp. 348–85.

[12] Hayek, Friedrich August von (1996): "Can We Still Avoid Inflation?" The Austrian Theory of the Trade Cycle and Other Essays, Ebening, Richard, ed., Auburn: Ludwig von Mises Institute, p. 88.

[13] Baumol, W.J. (1990): "Entrepreneurship: Productive, Unproductive, and Destructive," The Journal of Political Economy 98 (5) Part 1, pp. 893–921.

[14] Spain's boom in its renewable energy sector was partly enabled by low interest rates. Again, there is no problem with low interest rates as such. But if they are not determined by consumer decisions, and are therefore below the level that a free market would have set, they misallocate scarce funds is caused. See Instituto Juan de Mariana (2009): Study of the Effects of Public Aid to Renewable Energy Sources, pp. 19–20.Download PDF