Peter F. Drucker:

Modern Prophets: Schumpeter and Keynes?

The two greatest economists of this century, Jospeh A. Shumpeter and John Maynard

Keynes, were born, only a few months apart, a hundred years ago: Schumpeter on

February 8, 1883, in a provincial Austrian town; Keynes on June 5, 1883, in Cambridge,

England. (And they died only four years apart - Schumpeter in Connecticut on January 8,

1950, Keynes in southern England on April 21, 1946.) The centenary of Keynes's birth is

being celebrated with a host of books, articles, conferences, adn speeches. If the

centenary of Schumpeter's birth were noticed at all, it would be in a small doctoral

seminar. And yet it is becoming increasingly clear that it is Schumpeter who will shape

the thinking and inform the questions on economic policy for the rest of this century, if

not for the next thirty or fifty years.

The two men were not antagonists. Both challenged longstanding assumptions. The

opponents of Keynes were the very "Austrians" Schumpeter himself had broken away

from as a student, the neoclassical economists of the Austrian School. And although

Schumpeter considered all of Keynes's answers wrong, or at least misleading, he was a

sympathetic critic. Indeed, it was Schumpeter who established Keynes in America. When

Keynes's masterpiece, The General Theory of Employment, Interest and Money, came

out in 1936, Schumpeter, by then the senior member of Harvard economics faculty, told

his students to read the book and told them also that Keynes's work had totally

superseded his own earlier writings on money.

Keynes, in turn, considered Schumpeter one of the few contemporary economists worthy

of his respect. In his lectures he again and again referred to the works Schumpeter had

published during World War I, and especially to Schumpeter's essay on Rechenpfennige

(that is, money of account) s the initial stimulus for his on thoughts on money. Keynes's

most successful policy initiative, the proposal that Britain and the United States finance

World War II by taxes rather than by borrowing, came directly out of Schumpeter's 1918

warning of the disastrous consequences of the debt financing of World War I.

Schumpeter and Keynes are often contrasted politically, with Schumpeter being portraye

as the "conservative" and Keynes the "radical." The opposite is more nearly right.

Politically Keynes's views were quite similar to what we now call "neoconservatice." His

theory had its origins in his passionate attachment to the free market and in his desire to

keep politicans and governments out of it. Schumpeter, by contrast, had serious doubts

about the free market. He thought that an "intelligent monopoly" - the American Bell

Telephone system, for instance - had a great deal to recommend itself. It could afford to

take the long view instead of being driven from transaction to transaction by short-term

expediency. His closest friend for many years was the most radical and most doctrinaire

of Europe's left-wing socialists, the Austrian Otto Bauer, who, though staunchly

anticommunist, was even more anticapitalist. And Schumpeter, although never even

close to being a socialist himself, served during 1919 as minister of finance in Austria's

only socialist government between the wars. Schumpeter always maintained that Marx

had been dead wrong in every one of his answers. But he still considered himself a son of

Marx and held him in greater esteem than any other economist. At least, so he argued,

Marx asked the right questions, and to Schumpeter questions were always more

important than answers.

The differences between Schumpeter and Keynes go much deeper than economic

theorems or political views. The two saw a different economic reality, were concerned

with different problems, and defined economics quite differently. These differences are

highly important to an understanding of today's economic world.

Keyned, for all that he broke with classical economics, operated entirely within its

framework. He was an heretic rather than an infidel. Economics, for Keynes, was the

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equilibrium economics of Ricardo's 1810 theories, which dominated the nineteenth

century. This economics deals with a closed system and a static one. Keynes's key

question was the same question the nineteenth-century economists had asked: "How can

one maintain an economy in balance and stasis?"

For Keynes, the main problems of econimics are the relationship between the "real

economy" of goods and services and the "symbol economy" of money and credit; the

relationship between individuals and businesses and the "macroeconomy" of the nationstate;

and finally, whether production (that is, supply) or consumption (that is, demand)

provides the driving force of the economy. In this sense Keynes was in a direct line with

Ricardo, John Stuart Mill, the "Austrians," and Alfred Marshall. However much they

differed otherwise, most of these nineteenth-century economists, and that includes Marx,

had given the same answers to these questions: The "real economy" controls, and

money is only the "wil of things," the microeconomy of individuals and businesses

determines, and government can, at best, correct minor discrepancies and, at worst,

create dislocations; and supply controls, with demand a function of it.

Keynes asked the same questions that Ricardo, Mill, Marx, the "Austrians," and Marshall

had asked but, with unprecedented audacity, turned every one of the answers upside

down. In the Keynesian system, the "symbol economy" of money and credit are "real,"

and goods and services dependent on it and its shadows. The macroeconomy - the

economy of the nation-state - is everything, with individuals and firms having neither

power to influence, let alone to direct, the economy nor the ability to make effective

decisions counter to the forces of the macroeconomy. And economic phenomena, capital

formation, productivity, and employment are functions of demand.

By now we know, as Schumpeter knew fifty years ago, that every one of these Keynesian

answers is the wrong answer. At least they are valid only for special cases and within

fairly narrow ranges. Take, for instance, Keynes's key theorem: that monetary events -

government deficits, interest rates, credit volume, and volume of money in circulation -

determine demand and with it economic conditions. This assumes, as Keynes himself

stressed, that the turnover velocity of money is constant and not capable of being

changed over the short term by individuals or firms. Schumpeter pointed out fifty years

ago that all evidence negates this assumption. And indeed, whenever tried, Keynesian

economic policies, whether in the original Keynesian or in the modified Friedman version,

have been defeated by the microeconomy of business and individuals, unpredictably and

without warning, changing the turnover velocity of money almost overnight.

When the Keynesian prescriptions were initially tried - in the United States in the early

New Deal days - they seemed at first to work. But then, around 1935 or so, consumers

and businesses suddenly sharply reduced the trunover velocity of money within a few

short months, which aborted a recovery based on government deficit spending and

brought about a second collapse of the stock market in 1937. The best example,

however, is what happened in this country in 1981 and 1982. The Federal Reserve's

purposeful attempt to control the economy by controlling the money supply was largely

defeated by consumers and businesses who suddenly and most violently shifted deposits

from thrifts into money-market funds and from long-term investments into liquid assets -

that is, from low-velocity into high-velocity money - to the point where no one could

really tell anymore what the money supply is or even what the term means. Individuals

and businesses seeking to optimize their self-interest and guided by their perception of

economic reality will always find a way to beat the "system" - whether, as in the Soviet

bloc, through converting the entire economy into one gigantic black market or, as in the

United States in 1981 and 1982, through transforming the financial system overnight

despite laws, regulations, or econimists.

This does not mean that economics is likely to return to pre-Keynesian neoclassicism.

Keynes's critique of the neoclassic answers is as definitive as Schumpeter's critique of

Keynes. But because we now know that individuals can and will defeat the system, we

have lost the certainty which Keynes imposed on economics and wich has made the

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Keynesian system the lodestar of economic theory and economic policy for fifty years.

Both Friedman's monetarism and supply-side economics are desperate attempts to patch

up the Keynesian system of equilibrium economics. But it is unlikely that either can

restore the self-contained, self-confident equilibrium economics, let alone an economic

theory or an economic policy in which one factor, whether government spending, interest

rates, money supply, or tax cuts, controls the economy predictably and with nearcertainty.

That the Keynesian answer were not going to prove any more valid than the pre-

Keynesian ones that they replaced was clear to Schumpeter from the beginning. But to

him this was much less important than that the Keynesian questions - the questions of

Keynes's predecessors as well - were not, Schumpeter thought, the important questions

at all. To him the basic fallacy was the very assumption that the healthy, the "normal,"

economy is an economy in static equilibrium. Schumpeter, from his student days on, held

that a modern economy is always in dynamic disequilibrium. Schumpeter's economy is

not a closed system like Newton's universe - or Keynes's macroeconomy. It is forever

growing and changing and is biological rather than mechanistic in nature. If Keynes was

a "heretic," Schumpeter was an "infidel."

Schumpeter was himself a student of the great men of Austrian economics and at a time

when Vienna was the world capital of economic theory. He held his teachers in lifelong

affection. But his doctoral dissertation - it became the earliest of his great books, The

Theory of Economic Development (which in its original German version came out in

1911, when Schumpeter was only twenty-eight years old) - starts out with the assertion

that the central problem of economics is not equilibrium but structural change. This then

led to Schumpeter's famous theorem of the innovator as the true subject of economics.

Classical economics considered innovation to be outside the system, as Keynes did, too.

Innovation belonged in the category of "outside catastrophies" like earthquakes, climate,

or war, which, everybody knew, have profound influence on the economy but are not

part of economics. Schumpeter insisted that, on the contrary, innovation - that is,

entrepeneurship that moves resources from old and obsolescent to new and more

productive employments - is the very essence of economics and most certainly of a

modern economy.

He derived this notion, as he was the first to admit, from Marx. But he used it to disprove

Marx. Schumpeter's Economic Development does what neither the classical economists

nor Marx nor Keynes was able to do: It makes profit fulfill an economic function. In the

economy of change and innovation, profit, in contrast to Marx and his theory, is not a

Mehrwert, a "surplus value" stolen from the workers. On the contrary, it is the only

source of jobs for workers and of labor income. The theory of economic development

shows that no one except the innovator makes a genuine "profit"; and the innovator's

profit is always quite short-lived. But innovation in Schumpeter's famous phrase is also

"creative destruction." It makes obsolete yesterday's capital equipment and capital

investment. The more an economy progresses, the more capital formation will it

therefore need. Thus what the classical economists - or the accountant or the stock

exchange - considers "profit" is a genuine cost, the cost of staying in business, the cost

of a future in which nothing is predictable except that today's profitable business will

become tomorrow's white elephant. Thus, capital formation and productivity are needed

to maintain the wealth-producing capacity of the economy and, above all, to maintain

today's jobs and to create tomnorrow's jobs.

Schumpeter's "innovator" with his "creative destruction" is the only theory so far to

explain why there is something we call "profit." The classical economists very well knew

that their theory did not give any rationale for profit. Indeed, in the equilibrium

economics of a closed economic system there is no place for profit, no justification for it,

no explanation of it. If profit is, however, a genuine cost, and especially if profit is the

only way to maintain jobs and to create new ones, then capitalism becomes again a

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moral system.

Morality and profits: The classical economists had pointed out that profit is needed as the

incentive for the risk taker. But is this not really a bribe and thus impossible to justify

morally? This dilemma had driven the most brilliant of the nineteenth-century

economists, John Stuart Mill, to embrace socialism in his later years. It had made it easy

for Marx to fuse dispassionate analysis of the "system" with the moral revulsion of an Old

Testament prophet against the exploiters. The weakness on moral grounds of the profit

incentive enabled Marx at once to condemn the capitalist as wicked and imoral and

assert "scientifically" that he serves no function and that his speedy demise is

"inevitable." As soon, however, as one shifts from the axiom of an unchanging, selfcontained,

closed economy to Schumpeter's dynamic, growing, moving, changing

economy, what is called profit is on longer immoral. It becomes a moral imperative.

Indeed, the question then is no longer the question that agitated the classicists and still

agitated Keynes: How can the economy be structured to minimize the bribe of the

functionless surplus called profit that has to be handed over to the capitalist to keep the

economy going? The question in Schumpeter's economics is always, Is there sufficient

profit? Is there adequate capital formation to provide for the costs of the future, the

costs of staying in business, the costs of "creative destruction"?

This alone makes Schumpeter's economic model the only one that can serve as the

starting point for the economic policies we need. Clearly the Keynesian - or classicist -

treatment of innovation as being "outside," and in fact peripheral to, the economy and

with minimum impact on it, can no longer be maintained (if it ever could have been). The

basic question of economic theory and economic policy, especially in highly developed

countries, is clearly: How can capital formation and productivity be maintained so that

rapid technological change as well as employment can be sustained? What is the

minimum profit needed to defray the costs of the future? What is the minimum profit

needed, above all, to maintain jobs and to create new ones?

Schumpeter gave no answer; he did not much believe in answers. But seventy years

ago, as a very young man, he asked what is clearly going to be the central question of

economic theory and economic policy in the years to come.

And then, during World War I, Schumpeter realized, long before anyone else - and a

good ten years before Keynes did - that economic reality was changing. He realized that

World War I had brought about the monetarization of the economies of all belligerents.

Country after country, including his own still fairly backward Austria-Hungary, had

succeeded during the war in mobilizing the entire liquid wealth of the community, partly

through taxation but mainly through borrowing. Money and credit, rather than goods and

services, had become the "real economy."

In a brilliant essay published in a German economic journal in July 1918 - when the

world Schumpeter had grown up in and had known was crashing down around his ears -

he argued that, from now on, money and credit would be the lever of control. What he

argued was that neither supply of goods, as the classicists had argued, nor demand for

goods, as some of the earlier dissenters had maintained, was going to be controlling

anymore. Monetary factors - deficits, money, credit, taxes - were going to be the

determinants of economic activity and of the allocation of resources.

This is, of course, the same insight on which Keynes later built his General Theory. But

Schumpeter's conclusions were radically different from those Keynes reached. Keynes

came to the conclusion that the emergence of the symbol economy of money and credit

made possible the "economist-king," the scientific economist, who by playing on a few

simple monetary keys - government spending, the interest rate, the volume of credit, or

the amount of money in circulation - would maintain permanent equilibrium with full

employment, prosperity, and stability. But Schumpeter's conclusion was that the

emergence of the symbol economy as the dominant economy opened the door to

tyranny, and, in fact, invited tyranny. That the economist now proclaimed himself

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infallible, he considered pure hubris. But, above all, he saw that it was not going to be

economists who would exercise the power, but politicians and generals.

And then, in the same year, just before World War I ended, Schumpeter published The

Tax State ("The Fiscal State" would be a better translation). Again, the insight is the

same Keynes reached fifteen years later (and, as he often acknowledged, thanks to

Schumpeter): the modern state, through the mechanisms of taxation and borrowing, has

acquired the power to shift inome and, through "transfer payments," to control the

distribution of the national product. To Keynes this power was a magic wand to achieve

both social justice and economic progress, and both economic stability and fiscal

responsibility. To Schumpeter - perhaps because he, unlike Keynes, was a student of

both Marx and history - this power was an invitation to political irresponsibilty, because it

eliminated al econimic safeguards against inflation. In the past the inability of the state

to tax more than a very small proportion of the gross national product, or to borrow

more than a very small part of the country's wealth, had made inflation self-limiting. Now

the only safeguard against inflation would be political, that is, self-discipline. And

Schumpeter was not very sanguine about the politician's capacity for self-descipline.

Schumpeter's work as an economist after World War I is of great importance to economic

theory. He became one of the fathers of business cycle theory.

But Schumpeter's real contribution during the thirty-two years between the end of World

War I and his death in 1950 was as a political economist. In 1942, when everyone was

scared of a worldwide deflationary depression, Schumpeter published his best-known

book, Capitalism, Socialism and Democracy, still, and deservedly, read widely. In this

book he argued that capitalism would be destroyed by its own success. This would breed

what we would now call the new class: bureaucrats, intellectuals, professors, lawyers,

journalists, all of them beneficiaries of capitalism's economic fruits and, in fact,

parasitical on them, and yet all of them opposed to the ethos of wealth production, of

saving, and of allocating resources to economic productivity. The forty years since this

book appeared have surely proved Schumpeter to be major prophet.

And then he proceeded to argue that capitalism would be destroyed by the very

democracy it had helped to create and made possible. For in a democracy, to be popular,

government would increasingly shift income from producer to nonproducer, would

increasingly move income from where it would be saved and become capital for

tomorrow to where it would be consumed. Government in a democracy would thus be

under increasing inflationary pressure. Eventually, he prophesied, inflation would destroy

both democracy and capitalism.

When he wrote this in 1942, almost everybody laughed. Nothing seemed less likely than

an inflation based on economic success. Now, forty years later, this has emerged as the

central problem of democracy and of a free-market economy alike, just as Schumpeter

had prophesied.

The Keynesian in the 1940s ushered in their "promised land," in which the economistking

would guarantee the perfect equilibrium of an eternally stable economy through

control of money, credit, spending, and taxes. Schumpeter, however, increasingly

concerned himself with the question of how the public sector could be controlled and

limited so as to maintain political freedom and an economy capable of performance,

growth, and change. When death overtook him at his desk, he was revising the

presidential address he had given to the American Economic Association only a few days

earlier. The last sentence he wrote wa "The stagnationists are wrong in their diagnosis of

the reason the capitalist process should stagnate; they may still turn out to be right in

their prognosis that it will stagnate - with sufficient help from the public sector."

Keynes's best-known saying is surely "In the long run we are all dead." This is one of the

most fatuous remarks ever made. Of course, in the long run we are all dead. But Keynes

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in a wiser moment remarked that the deeds of today's politicians are usually based on

the theorems of long-dead econimists. And it is a total fallacy that, as Keynes implies,

optimizing the short term creates the right long-term future. Keynes is in large measure

responsible for the extreme short-term focus of modern politics, of modern economics,

and of modern business - the short-term focus that is now, with considerable justice,

considered a major weakness of American policymakers, both in government and in

business.

Schumpeter also knew that policies have to fit the short term. He learned this lesson the

hard way - as minister of finance in the newly formed Austrian republic in which he,

totally unsuccessfully, tried to stop inflation before it got out of hand. He knew that he

had failed because his measures were not acceptable in the short term - the very

measures that, two years later, a noneconomist, a politician and professor of moral

theology did apply to stop the inflation, but only after it had all but destroyed Austria's

economy and middle class.

But Schumpeter also knew that today's short-term measures have long-term impacts.

They irrevocably make the future. Not to think through the futurity of short-term

decisions and their impact long after "we are all dead" is irresponsible. It also leads to

the wrong decisions. It is this constant emphasis in Schumpeter on thinking through the

long-term consequences of the xpedient, the popular, the clever, and the brilliant that

makes him a great economist and the appropriate guide for today, when short-run,

clever, brilliant economics - and short-run, clever, brilliant politics - have become

bankrupt.

In some ways, Keynes and Schumpeter replayed the best-known confrontation of

philsophers in the Western tradition - the Platonic dialogue between Parmenides, the

brilliant, clever, irresistible sophist, and the slow-moving and ugly, but wise Socrates. No

one in the interwar years was more brilliant, more clever than Keynes. Schumpeter, by

contrast, appeared pedestrian - but he had wisdom. Cleverness carries the day. But

wisdom endureth.