Prolegomena to economic development

John Medaille, writes a very insightful meditation on money [1] which resonates with a view on economic development along Schumpeter’s theory of economic development. Among other things, he says

The borrower may write checks against these credits, and at the end of the day the bankers settle up the checks between each other; no cash is involved. Now, this would not be a problem if the money was always lent for productive purposes.

Indeed–for instance, according to Schumpeter’s theory of development [2], credit, speaking strictly in the context of development, is only created in order to provide purchasing power to an entrepreneur (E) to use to acquire specifically production goods (a.k.a., means of production). Since this new purchasing power comes from outside the theoretical circular flow of the regular economic life (i.e., a process sans development, although potentially with growth, “a commercially organized state, one in which private property, division of labor, and free competition prevail”, an abstraction, no doubt “but only for the purpose of exhibiting the essence of what actually happens”), E is taking these production goods away from their current use and employing/deploying them elsewhere and putting them to new uses. In the process he causes their prices to rise. The credit is extinguished later when the goods produced by E generate enough (in case of success) to pay off the debt and interest, etc. Only in this case, Schumpeter says, inflation is controlled and rules can be derived to determine the magnitude of the possible creation of purchasing power by the bank.

In this circular flow of economic life (not just of money, as John observes apropos of Lonergan [3]) “there is no profit” in the sense of entrepreneurial profit and it can grind along for ever. Roughly speaking, “we can imagine that the products of all individuals form a heap [a ‘social reservoir’] somewhere at the end of the economic period, which is then distributed according to certain principles,” and “to each contribution there corresponds somewhere in the system a claim of another individual.” This system is thus in equilibrium.

He then starts tugging at the various assumptions of that model in light of a central guiding idea which Kant, for instance, expressed as “how is something new possible?” (see, for instance, Prolegomena to the Critique of Pure Reason)–specifically, “how is development possible?” rather than simply growth. Note that in a circular flow economy growth is indeed possible, whereas development in his sense is not.

The core of Schumpeter’s view is that “the new” is driven by the entrepreneur through finding “new combinations” of existing production goods (goods used to produce other goods such as consumption goods) to create new products–that’s strategically speaking. Tactically, this is all made possible through the “creation of purchasing power” that the entrepreneur “borrows” (through debt or equity, it does not matter for Schumpeter’s argument just like it did not matter for Modigliani and Miller’s Theorem, a.k.a. MM 1, and the heart of their modern capital structure can definitely be found in Schumpeter’s 1911 writings). Now the creators of purchasing power par excellence are the banks, of course. (I couldn’t tell you what Schumpeter thought about the view of the development of capitalism unto an eventual financial capitalism, a la Sombart).

In the circular flow posited by Schumpeter, there is no (or very little, through savings) available purchasing power that an entrepreneur can borrow to fund his new combination of production goods (since all is in equilibrium within “empirically known market opportunities”). So, for any development to take place, the banks “must”, of necessity, create purchasing power, this function becoming therefore fundamental, sine qua non, rather than a nice-to-have, to any development–because there is no other source for new purchasing power. If the entrepreneurial venture is successful, then the value created through the new products will absorb the credit thus created (the entrepreneur pays back his loan and interest thus “mopping up the liquidity” previously created for him) and there is, at the end of the venture, qua venture [4], no inflation. If the venture fails, then that’s another story, of course. And the ability to manipulate that process is what the quotes I listed from Schumpeter warned about.

In any case, Schumpeter was prescient: in ch. 3, “Capital and Credit”, of Theory of Economic Development, he indicates (originally in 1911!), while looking to find by what is credit creation (for development (!) in his case) limited, that:

Only in one other case could the banking world, if it were released from its obligation of redeeming its means of payment in gold and if the regard for international exchange were suspended, start inflation and arbitrarily determine the price level, not only without loss but even with profit (my emph.): namely, if it pumped credit means of payment into the circular flow either by making bad commitments good by a further creation of new circulating media or by giving credits which really serve consumptive ends. (my emph. [5])

Of course, no bank by itself has the wherewithal to do this, provided there is a lot of them and they are not…“cartelized”,

But all banks together could do it. They could…continually give additional credit and precisely through its effect upon prices make good that [credit which was] given previously.

So, he continues, there should be legal control of this activity and limits in place. I would add, that even though those may exist, they also have to be enforced–and even judges now seem to realize that latter requirement may not even be close to being fulfilled, at least with regard to some of SEC prosecutions [6] at least in the on-going saga of the Citicorp fraud investigation.

In any case, Schumpeter concludes

Just as the state, under certain circumstances, can print notes without any assignable limit, so the banks could do likewise if the state–for it comes to this–were to transfer the right to them in their interest and for their purposes, and commons sense did not prevent them from exercising it.

Again, this was written in 1911 (with minor modifications in 1934)–a Wunderkind all right…


[1] John Medaille, Friends and Strangers: A Meditation on Money, The Distributist Review,, retrieved 6 January 2012

[2] Joseph Schumpeter, The Theory of Economic Development, Transaction Publishers, New Brunswick, NJ: 1983


[4] The venture constitutes development only for a time. Once competition and “swarming” by other entrepreneurs take hold, the venture becomes part of the regular circular flow of economic life.

[5] As the current economic crisis is attributable to excess “consumptive” debt, the phrase is particularly pertinent

[6] E. Wyatt, “Judge Says S.E.C. Misled Two Courts in Citi Case”, The New York Times, 29 December 2011,, retrieved 6 January 2012


About socot

- Economie - Istorie economica - Finante - Administrarea crizelor
This entry was posted in Uncategorized and tagged , . Bookmark the permalink.