In the book, Schumpeter argued that capitalism will naturally evolve into socialism, that socialism can work, and that it is not logically incompatible with democracy. I will argue against all three of these claims.
What is capitalism? / Schumpeter is perhaps best remembered for his idea of “creative destruction.” He believed that capitalism had generated the highest standard of living ever known because it continually creates new consumer goods and services, new methods of production and transportation, new markets, and new forms of industrial organization, while destroying obsolete ways of doing things. In other words, capitalism is a process of invention and innovation that constantly disrupts the economy and improves people’s standard of living.
A related idea is that the capitalist businessman is always competing against other disruptors and threats of disruption, even if his industry is a monopoly or an oligopoly. Capitalist competition or threats of competition will “enforce behavior very similar to the perfectly competitive pattern” dear to economists. The relevance of this observation cannot be underestimated and extends to today’s economy.
The only “plausible capitalism” that Schumpeter could imagine, however, was a system made of large corporations. He argued that monopoly or oligopoly is the rule, perfect competition is the exception. The latter would in fact be less efficient and it has “no title to being set up as a model of ideal efficiency.” It is thus a mistake to think that government should regulate businesses to make them work as if they were small businesses in perfect competition.
Large businesses are the product of creative destruction, and they typically are both more efficient and more stable. Because of the strategic control they exercise on their prices and outputs, they are more adaptive and fare better in recessions. As for their market power, Schumpeter observes that cases of long-run monopoly are rare. Monopolies will not last long “unless buttressed by public authority” — another important observation. Given the organizational efficiency of big corporations with market power, he denies that their prices are necessarily higher and outputs smaller than they would be in some perfectly competitive industry. Thus, he correctly argues, there is no general case for trust busting.
Although there is much truth in his characterization of capitalism, it focuses too narrowly on big business and underestimates the diversity of free markets and the constant competitive pressure and threat from small competitors. Of course, one may put the label “capitalism” on whatever one wants, but how useful is a definition that ignores the rest of free-market businesses, including those that are not yet big? The economic system that produced a standard of living unrivaled in the history of mankind encompasses not only big business but all free-market activities.
Creative destruction is as much a product of small entrepreneurial firms as of the large ones that Schumpeter emphasizes. Walmart did not exist in 1968 nor Apple in 1975 nor SpaceX in 2001. Big corporations were once small and disruptive, and it is because of their disruptive success that they became large. And after some time, such firms are often pushed back down the ladder. Only 10% of Fortune’s largest American corporations in 1955 were still on the list in 2021, according to an analysis by Mark J. Perry of the American Enterprise Institute. Large companies often go bankrupt or are acquired or broken up: think of Pan Am, Borders, Sears, Blockbuster, etc. Many divest themselves of chunks of their businesses in order to survive: General Electric is a recent case. Except for growing regulation and protectionism, which favor incumbents, the churning of the business world continues.
Obsolete entrepreneurs / Another indication that Schumpeter’s concept of capitalism does not exactly correspond to the real world is his prediction of the obsolescence of entrepreneurs. We may think of them as the source of creative destruction, but he viewed future innovation as coming from “teams of trained specialists” that run the “giant industrial units” — a force of bureaucratization and automatization. Entrepreneurship and innovation would become routine. Economic growth would become more and more automatic. In brief, he thought that corporate bureaucrats would be the new entrepreneurs. Large firms would be so efficient that they would gradually eliminate the very function of the entrepreneur. Capitalism would “make itself superfluous.”
Schumpeter’s bureaucratic capitalism seems to leave little room for the messy free market and the individual liberty that goes with it. But experience, if not theory, shows that managers and entrepreneurs are two different animals, both important. We may thus suspect that the Schumpeterian concept of capitalism will prove too narrow for a meaningful comparison with socialism and democracy.
Efficiency of socialism / A commercial society, Schumpeter explained, is based on private property of the means of production or capital — that is, buildings, equipment, and other investments in future production — and on regulation by either private contract or by the private planning of large corporations. A socialist society, by contrast, is based on a central authority’s ownership of, or control over, the means of production. This definition is close to the Marxist definition, the softer idea of “control” being an addendum by Schumpeter. It is also important to understand that, for him, socialism (at least in its centralist version) and communism are synonymous.
Schumpeter said he did not advocate socialism nor prophesy or predict it, but that he was simply trying “to diagnose observable tendencies and to state what results would be, if these tendencies should work themselves out according to their logic.”
So how did he expect socialism to work? He made the “bold assumption” that the central socialist authority would give its agents enough latitude and initiative to run production efficiently: no micromanagement of businesses. Starting from this assumption, he demonstrated — or claimed to demonstrate — that Austrian economist Ludwig von Mises was wrong to judge efficient socialism as impossible. On the contrary, claimed Schumpeter, the “socialist blueprint” can be as logically coherent as the market system.
His blueprint works as follows: The government would redistribute “incomes” — that is, claims to consumption — and then let consumers express their demands on the market. “There exists no more democratic institution than a market,” he writes. The “central [planning] board” would simply allocate “the means of production” to industries according to consumer demand. Maintaining optimality of the system in the face of economic change, Schumpeter recognized, would require either some inequality of incomes (paying workers more to produce goods heavily in demand) or the coercive assignment of workers to the jobs necessary to satisfy consumer demand; he preferred the former.
Socialism would surpass capitalism in productive efficiency, he claimed. Industries and state firms would be better coordinated. Uncertainty would diminish, which would facilitate forecasting. Less unemployment and waste would result. Specifically criticizing Friedrich Hayek (another Austrian economist and 1974 Nobel economics laureate) and Hayek’s former London School of Economics colleague Lloyd Robbins, Schumpeter emphasized that economic planning is as efficient in the public sector as in “capitalist” firms. Assisted by “a huge bureaucracy,” the planning board would do “a survey of the available resources and technologies” and compare them to demand using “a general knowledge about what kind of people the comrades are.” Given consumer demand, he argued, the distribution of inputs among different industries automatically follows. Adjustments would be made by trial and error. He wrote:
Paradoxical as it sounds, individualism and socialism are not necessarily opposites. One may argue that the socialist form of organization will guarantee “truly” individualistic realization of personality. This would in fact be quite in the Marxian line.
Schumpeter found many exceptions in how the socialist blueprint could work in practice. He recognized that the political authorities could deny consumer choices to avoid “outright beefsteak socialism” — that is, to avoid the proletarians wanting something other than what the state thinks they should consume. He also seemed to admit the necessity of a central authority to evaluate the “economic significance” of the factors of production (inputs), including labor, in the absence of a free market. So, coercing workers might, after all, be in the cards.
And note my italics in the following quotes from Capitalism, Socialism and Democracy: In case of unemployment, “the ministry of production will be in a position — whatever it may actually do — to redirect the men to other employments which, if the planning lives up to its possibilities, might in each case be waiting for them.” “In the socialist order, improvements could theoretically be decreed and inefficiencies be promptly eliminated.” But Schumpeter added:
Of course, the likelihood of this particular advantage … being realized by a bureaucracy is another matter. … That possible superiorities might in practice turn into actual inferiorities must be kept in mind throughout.
Capitalism is doomed, regardless / However socialism compares with capitalism matters little, anyway, because the latter is doomed, claimed Schumpeter.
Can capitalism survive? “No,” he answered.
I don’t think it can. … Its very success undermines the social institutions which protect it, and “inevitably” create conditions in which it will not be able to live and which strongly point to socialism as to the heir apparent.
This is a major Schumpeterian idea: capitalism destroys itself because of its very efficiency, which eliminates the function of the entrepreneur in favor of big-business bureaucracy. The system automatically moves toward bureaucratic socialism. I’ve already reviewed his reasoning on this, but other reasons also doom capitalism.
Those reasons relate to the self-destruction of the institutional framework of capitalism. Because of its efficiency, big-business capitalism cannibalizes “the lower strata of the capitalist industry”: the small producer and trader; the small and medium firms. Private property is blurred by big units. Freedom of contracting is replaced by “stereotyped, unindividual, impersonal, and bureaucratized contract”; the labor contract is an example. Truly “private” (the scare quotes are from Schumpeter) economic activity fades.
The intellectuals give a voice to, and nurse, any resentment against capitalism. Intellectuals are those people who wield the power of language, “have no direct responsibility for practical affairs,” and may have the best chance of asserting themselves by being a nuisance. It was capitalism that let them loose. The “bourgeois class” protects them “because the freedom it disapproves cannot be crushed without also crushing the freedom it approves.” Only a socialist or fascist society would be strong enough to control intellectuals. On top of all that, the expansion of higher education increases the number of unemployable and thus resentful intellectuals.
“Extra-rational values” fuel the anti-capitalist social atmosphere. Hostility to capitalism, Schumpeter wrote, has become “almost a requirement of the etiquette of discussion.”
His whole argument on the demise of capitalism depends at least partly on what capitalism is and whether it is naturally becoming a socialist-like bureaucracy. It hopefully also depends on what people learn about economics and about socialism.
Problems with socialist planning / Let’s come back to Schumpeter’s argument on the economic efficiency of socialism, which is also problematic. Didn’t the reservations he expressed overcome the putative advantages of socialism? Why didn’t he see that? One hypothesis echoed by Harvard business historian Thomas K. McCraw in his introduction to the 2008 edition of the book is that Schumpeter’s praise for socialism was irony. He had to camouflage his conservative opinions lest his socialist readers put it down. In this view, apparently shared by other scholars, we would have to read the satire between the lines. At times, this interpretation does make sense, as when he scorns the “socialist religion,” “the Faith,” “the creed,” “the faithful.” But he still defends their system. So, what did Schumpeter really believe?
He had a good opportunity to settle that issue in the chapter he devoted to “the human element.” He might have emphasized his previous doubts that ordinary individuals may not behave like the socialist religion demands. But he did not. He continued to argue that the socialist alternative survives the comparison with capitalism, depending on what the historical circumstances are. In a society ready for socialism, he explained, most people’s work would not change. The corporate bureaucrats would painlessly switch from the private to the public sector. If income inequality in their favor were not deemed acceptable under socialism, the high-level bureaucrats could be “compensated not only by honors but also by official residences staffed at the public expense, allowances for ‘official’ hospitality, the use of admiralty and other yachts,” and such. OK, perhaps we can find some satire there!
The central authority, Schumpeter said, will be able to enforce worker discipline much better than capitalist firms can: “A strike would be mutiny.” It is the principle of the required discipline that matters, he explained, not the particular form that it had taken in the Soviet Union. The “socialist order” will command “moral allegiance.” State planning will also have the benefit of making the nature of economic phenomena clearer — for example, the primacy of imports over exports. With due respect for the great economist, if this is not satire, it looks naïve.
Other problems mar Schumpeter’s discussion. Except for reminders that capitalism has created a higher standard of living than was ever possible before, his comparison focused on productive efficiency rather than on consumers’ satisfaction, ignoring that the latter is essential to the economic concept of efficiency.
Some of his statements are either obscure or strain credulity. For example, he wrote that “planning of progress” would allow “the systemic coordination and orderly distribution in time of new ventures in all lines.” Does this mean that, like New-Dealer Rexford Guy Tugwell believed in the 1930s, committees of bureaucrats should decide what new industry — say, automobiles or, to use more recent illustrations, maritime containers, iPhones, or online shopping — will be allowed? (See “Total Regulation for the Greater Whole,” Fall 2014.)
What of Schumpeter’s claim that the “freedom of consumers’ choice” could be greater under socialism? This idea, dear to economists who advocated “market socialism,” appears optimistic at the very least. For sure, with more equal incomes, the individuals on the right side of the redistribution could consume more than otherwise; but those on the wrong side would see their consumption decrease. Ignoring this problem, a major one remains: how to make sure that employees move to the jobs that produce the (continuously changing) configuration of goods and services that consumers want? We are back to the problem of labor allocation, with which Schumpeter seemed to struggle.
In his 1944 book The Road to Serfdom, Hayek convincingly argued that economic planning would require the coercive allocation of labor if remunerations were not set on free labor markets. But such markets defeat the politically determined redistribution under socialism. (See “Where Are We on the Road to Serfdom?” Fall 2021.)
More generally and fundamentally, Capitalism, Socialism and Democracy ignored the demonstration that Ludwig von Mises and Hayek had provided in the 1920s and 1930s to the effect that socialist “calculation” is impossible. The problem is how to calculate what to produce and how to produce it if there are no prices to signal the conditions of demand and supply in both the product markets and the input markets. In his 1945 American Economic Review article “The Use of Knowledge in Society,” Hayek pointed out that Schumpeter’s book had not answered that question and he further explained why socialist efficiency is impossible.
In a nutshell, Hayek’s argument is that market prices incorporate essential information about demand and supply conditions. Without such information, it is impossible for the planning authority to know not only what consumers want, given their preferences and what they are willing to pay, but also which factors of production are more or less scarce and how to use them efficiently. He criticizes Schumpeter for assuming (as we saw) that once the planners have hypothetically found how many units of, say, TV services consumers want and are willing to pay at each possible price, the required prices of the necessary inputs would be known automatically. This is not true, because every input can also be used for producing other goods and services. In other words, the supply of inputs (say, labor) matters in determining their prices (wages in the case of labor). Moreover, different types of inputs have different productivity in producing different goods. Without market prices, there is no way to determine the most efficient combination of factors to use — say, more labor or more machines.
Even with today’s computers, central planners cannot make these calculations. The necessary information is dispersed among the participants in the economy. It is not a matter of scientific information, but of information of time and place on the myriads of local conditions of production and of information on the consumption tradeoffs consumers are willing to make. This information does not, and cannot, reside in a single person’s head — or in a bureaucratic committee. Notwithstanding Schumpeter, no survey and no planner’s intuition can reveal this information, which changes continuously. Hence, socialist calculation is impossible and planning decisions cannot be rational and efficient.
Because neither capitalism nor socialism works as Schumpeter believed, his theory that mature capitalism will naturally evolve into socialism is unsound. This, of course, does not imply that the other cultural and institutional factors he invokes may not threaten capitalism or free markets in general.
True and false democracy / Democracy is the third pole of analysis in Capitalism, Socialism and Democracy. What is democracy and is socialism compatible with it? To answer those questions, Schumpeter developed a theory of democracy that was quite ahead of its time. Despite some loose ends, it may be the most interesting part of the book.
He argued against the classical Rousseauian conception of democracy. It cannot be the rule of the people. The people do not have a common will because there is no unanimous common good, only different individual conceptions of what good is. It follows that a political decision cannot represent what people really want in any meaningful sense; it may even be “distasteful to all of the people.” The will of the majority is only (at best) the will of the majority, not the will of all the people. This analysis prefigured the economic theory of social choice that would be launched by Kenneth Arrow and popularized among political scientists by William Riker decades after Capitalism, Socialism and Democracy. (See “Populist Choices Are Meaningless,” Spring 2021.)
Schumpeter remarked that there is more rationality in economic decisions than in public choices because the latter are detached from personal responsibility. He came close to the notion of voters’ “rational ignorance” later developed by public choice theorists. He wrote:
[The private citizen] is a member of an unworkable committee, the committee of the whole nation, and this is why he expends less disciplined effort on mastering a political problem than he expends on a game of bridge. …
The typical citizen drops down to a lower level of mental performance as soon as he enters the political field. He argues and analyzes in a way which he would readily recognize as infantile within the sphere of his own interests.
It is consequently easy for “groups with an ax to grind” to manipulate the “will of the people.” The mythical classical doctrine of democracy is still generally accepted because it is a sort of religious belief or because politicians benefit from the myth.
In Schumpeter’s conception of democracy, the role of the voters is only “to produce a government.” Democracy is simply a method for choosing the leaders through a competitive struggle for votes. This competition is analogous to economic competition: “Everyone is free to compete for political leadership … in the same sense in which everyone is free to start another textile mill.” Schumpeter, McCraw tells us in his introduction, “was known for his good cheer, polished manner, and mischievous wit.”
So far so good for democracy, except that Capitalism, Socialism and Democracy shows little or no classical-liberal conscience of the necessity of limiting government power. For Schumpeter, political parties are “the essence of politics” and “democracy is the rule of the politician.”
It is a puzzling book. The Harvard professor went on to argue that this sort of democracy could be compatible with socialism under certain conditions. Society must be “mature” in the sense that the “socialization” — a soft word for “nationalization” — of the economy is already advanced and that a large bureaucracy can prevent inefficient interference from politicians. But maintaining democracy may be “extremely delicate.” “After all,” he wrote, “effective management of the socialist economy means dictatorship not of but over the proletariat in the factory.” The workers are “sovereign” only at election time.
Lest the workers use their electoral sovereignty to relax the necessary discipline of the factory, a socialist government “may” decide to reduce political competition. Interestingly, economist and political philosopher Anthony de Jasay would later independently develop a similar but more radical theory: after abolishing political competition, Leviathan, which would be the employer of all “citizens,” would establish a sort of plantation state, he explained in his 1985 book The State. Although not as pessimistic (or realistic), Schumpeter observed that few socialist parties in the world made democracy their main goal.
Schumpeter’s vision of democracy has only a tenuous relation to individual liberty. He saw “individual freedom” (previously identified with “individual self-government”) as guaranteed by political competition because “in most cases though not in all” it implies “freedom of discussion for all.” He added that “it is all there is to that relation.” This narrow political freedom, the vanishing freedom of the entrepreneur, and the very uncertain freedom of the consumer seem to be all there is about individual liberty in Capitalism, Socialism and Democracy.
Conclusion / Schumpeter’s hypothesis that socialism and democracy could, under favorable conditions, be compatible is difficult to defend. Individual liberty has fused into socialist politics, just as capitalism naturally dissolves into economic socialism. In the narrow Schumpeterian definition of capitalism, creative destruction self-destructs.
As we saw, it is often not clear what the book’s conclusions are. Perhaps McCraw is right that we must read the satire between the lines, but he himself seems a bit confused about political ideologies. He states that “Hayek and Schumpeter considered themselves conservatives,” seemingly unaware that Hayek, five decades before, had titled the postscript of his 1960 book The Constitution of Liberty, “Why I Am Not a Conservative.”
Did Schumpeter’s methodology lead him astray? Probably under the influence of Marx, whom he thought was an important economist, he was tempted by historicism, the idea that there exist immutable laws of historical development. For example, Schumpeter wrote that “things and souls shape themselves for socialism automatically, i.e., independently of anyone’s volition and of any measures taken to that effect.” And he often used concepts that are foreign to methodological individualism, such as “social class,” “collective mind,” the “social body,” or “the soul of the nation.”
What are we left with? For the discerning reader, the book does defend some important ideas: the efficiency of creative destruction, the errors of antitrust laws, the irrationality of anti-capitalist hostility, and the mistaken conception of democracy as the rule of the people. This book is not necessarily easy to read, but its many challenging ideas do provoke reflection on fundamental questions of political philosophy. Perhaps, after all, it is a long, devastating satire against socialism.
