Twit the Ephor?

Alin Voicu

The phrase “creative destruction” has been used in the context of Romney’s career and campaign (recently here[1])and, as almost all those who adopt that phrase as their slogan, those who do have no clear idea about what it means.That it is associated with the great economist Joseph Schumpeter certainly is perceived by these people as a warrant to rather “destroy creatively,” to find new ways to blow things up in order to “create value.”  Which they don’t exactly do, of course–most of the techniques just shuffle the deck chairs on a shoestring (to creatively destroy some metaphors) until such time that a profitable “exit” can be made. Like many before him, Romney confuses cause and effect. In that view, the mob of boatmen of Munden who, in 1707, “ingeniously” found a legal way to destroy Papin’s breakthrough invention, a paddlewheel vessel powered by a steam engine which would find commercial success with Fulton’s Clermont on the Hudson River in 1807, are entrepreneurs just as much as Papin himself (or the other mob at Newton’s British Royal Society who apparently did some of its own “enterprising” to achieve that 100 year delay)![2]

However, unlike Marx and Sombart who also had a sense of the phenomenon described by this phrase, namely, the “spirit” of capitalism, Schumpeter always seemed to put creation before destruction not only from a timing standpoint but from a causal and endogenous one as well. This is intrinsic to the evolutionary character of economic development:

Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action; this fact is important and these changes (wars, revolutions and so on) often condition industrial change, but they are not its prime movers. Nor is this evolutionary character due to a quasi-automatic increase in population and capital or to the vagaries of monetary systems of which exactly the same thing holds true. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. [emph. added]

So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mail-coach to the airplane. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation [emph. added]—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.[3]

In one example, “Illinois Central”, at the time of the building of the railroads in the Midwest, “not only meant very good business whilst it was built and whilst new cities were built around it and land was cultivated, but it spelled the death sentence for the [old] agriculture of the West”[4]–creation comes before destruction causally. (And this would also makes sense even at a less vaunted level if we were just simply trying to avoid Bastiat’s broken window fallacy in the circular flow, no less).[5]  It is unclear whether the LBO model calculating a private equity investor’s internal rate of return (IRR) on a prospective deal constitutes “creation” in Schumpeter’s sense.

So tables can be turned on someone like Romney with regard to that other famous Schumpeterian concept beloved by him to the point of asking people at campaign rallies to stand up and be acknowledged: the “entrepreneur.”[6] Is someone like Mitt one such?

In The Theory of Economic Development, Schumpeter lists several activities that qualify the actor undertaking them as an entrepreneur which were later summarily mirrored in the passage quoted above. “By ‘development,’ therefore, we shall understand only such changes in economic life as are not forced upon it from without but arise by its own initiative, from within.”[7] Schumpeter links entrepreneurship exclusively with economic development and explicitly not with mere economic growth (understood as accretion,[8] which can occur in the circular flow as well). By the way, the confusion persists with most politicians in troubled EU who talk about growth as opposed to austerity.

Economic development, by contrast with growth in the circular flow, is not easily amenable to static economic analysis precisely because it presupposes something new, evolutionary and endogenous: destruction is not “new” in that sense–only creation can be: “yet innovations in the economic system do not as a rule take place in such a way that first new wants arise spontaneously in consumers and then the productive apparatus swings round through their pressure…”[9]

This explains, by the way, the rationale of the venture capital industry: trying to finance the development of products that would create the “new wants,” to stay ahead of the consumer in finding needs to fulfill, for better or worse. This is creative in the first place and only by “natural” consequence destructive. In an analysis of the evolution of new ventures aiming to shed light on the relative importance of the “jockey“ (management) or the “horse” (the company and its assets), Prof. Steve Kaplan of the University of Chicago Booth graduate school of business and a well known authority in the field, indirectly gives empiric support for this idea. “Dramatic revenue increases [are] driven by selling more to an initial customer type” of the new venture.[10] He also infers that revenues are driven secondarily by selling to other types of customers. This illustrates the concept of creating wants rather than responding to manifest ones. Even more so, some of the new ventures created different products, probably complementary to their main offering, that exploited secondary effects of their want-creation (think, for instance, smartphone cases–“think different”). Of course, this is not rocket-science.

Development in Schumpeter’s sense can have the following origins:

  1.  The introduction of a new good — that is one with which consumers are not yet familiar — or of a new quality of a good.
  2. The introduction of a new method of production, that is one not yet tested by experience in the branch of manufacture concerned, which need by no means be founded upon a discovery scientifically new, and can also exist in a new way of handling a commodity commercially.
  3. The opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.
  4. The conquest of a new source of supply of raw materials of half-manufactured goods, again irrespective of whether this source already exists or whether it has fist to be created.
  5. The carrying out of the new organization of any industry, like the creation of a monopoly position (for example through trustification) or the breaking up of a monopoly position. [11]

Romney’s type of work has greatest chance to qualify as entrepreneurship under the fifth entry in Schumpeter’s list. Indeed, Schumpeter mentions financiers and promoters as possible candidates for entrepreneurship insofar as they create new combination. In Mitt’s case, the “new organization” is not of an industry per se; rather, usually the control over an existing company changes hands (and, most often, heads), it’s officers and board members are switched out and a new operating philosophy and plan are put in place in order to create “value.” Loading up the target with debt generally has a disciplining effect[12] on management through the increased threat of financial distress, but it is not a qualitative, evolutionary change of the organization. The small gate that could gain Romney access into the entrepreneur class would be the buy-and-build (f.k.a., roll-up) aspect of private equity models. That could indeed, albeit rarely, alter an industry’s structure and squeeze the Governor into that coveted category.

However, typical activities remain in the domain of the Walrasian circular flow which Schumpeter sets as the grounding theoretical construct to understand both “pure [static] economics”, including economic growth, and the departure from it, which constitutes true development. It is therefore with growth that Romney would be associated, rather than development. He would be a capitalist rather than an entrepreneur. More on this later.

So, albeit with extreme laxity and non-lossless stretching, Romney may be considered an entrepreneur in Schumpeter sense; but, unfortunately for him, there is more to this story.

The self-nominated “only true Schumpeterian” economist [13], Nicholas Georgescu-Roegen, looked back on Schumpeter’s list and thought that the evolutionary aspect of economic development is the core of what an entrepreneur’s actions bring to bear.

As Schumpeter defined it, development consists of a “spontaneous and discontinuous” change that comes from within the economic process because of the very nature of that process. This change consists of some entirely new ways of combining the productive forces and materials, briefly, of new methods of production. Such a novelty changes the face of the economic world forever, that is, in an irreversible and irrevocable manner.

and

the introduction of a new method of production necessarily changes the spectrum of commodities and, conversely, such a change implies some innovation in the production technique. [14, emph. added]

He continues to say that ”from Schumpeter’s list of the possible origins of developmental changes [shown above], it appears, however, that he overlooked [the] factual equivalence [between change and innovation in the production technique].” Point 5. of Schumpeter’s comes closest to being disqualified by NGR–and that was the most favorable to Mitt’s making the case that he is an entrepreneur. Organizational change is unlikely to be a qualitative change and, moreover, may not alter the spectrum of commodities in the economy in Schumpeter’s sense.

But there is somewhat of saving grace–as a provider of buying power to entrepreneurs, in his case, in a somewhat more sophisticated fashion than a banker, Romney can contribute to economic development and not just circular flow accretion-growth. This does not allow him to take credit for the achievements and aura of the entrepreneurs proper, but it does allow him to take profits. While not a banker, Romney acts as an intermediary between the entrepreneur and his required new purchasing power particularly since private equity investments usually have a very large debt portion (credit):

The banker, therefore, is not so much primarily a middleman in the commodity “purchasing power” as a producer of this commodity. However, since all reserve funds and savings to-day usually flow to him, and the total demand for free purchasing power, whether existing or to be created, concentrates on him, he has either replaced private capitalists or become their agent; he has himself become the capitalist par excellence. He stands between those who wish to form new combinations and the possessors of productive means. He is essentially a phenomenon of development, though only when no central authority directs the social process. He makes possible the carrying out of new combinations, authorizes people, in the name of society as it were, to form them. He is the ephor of the exchange economy. [15, emph. added]

Insofar as the new purchasing power made available by Romney funds the new combinations envisioned by an entrepreneur, he looks like that “capitalist par excellence.” While that kind of funding may not usually be the case for a private equity investor, “Mitt the ephor” could make sense, maybe, at least as much as Mitt the Twit[16]. On the other hand, “Mitt the entrepreneur,” carrying forth the aura of being “innovative”, “authoritative”, capable of meaningful “foresight”[17]–most likely, not…  Because, after all, “the definition of the entrepreneur in terms of entrepreneurial profit instead of in terms of the function the performance of which creates the entrepreneurial profit is obviously not brilliant”![18]

Regardless, the discussion above helps position the private equity model vis-à-vis Schumpeter’s theory of development.

Notes:

  1. Murray, Charles, “Why Capitalism Has an Image Problem”, The Wall Street Journal, 30 July 2012, p. C1, an unbearable text giving ammunition to those who say that economists are notoriously ill-read, makes this connection in a pat-self-on-back fashion. (See, for example, Peter Groenewegen, “Defending economic rationalism … and boosting the image of ‘free market economists’?”,Economic and Labour Relations Review, Centre for  Applied Economic Research and Industrial Relations Research Centre, June 1994, vol. 5, Issue 1, I: “frequently observed characteristics of many economists [are that they are] often narrow in their focus, ill-read and ill-lettered, philosophical[ly] and historically ill-informed, and totally devoid of all signs of scholarly erudition and habits.”)
  2. Example suggested by Mihail Manoilescu’s use in his Forţele naţionale productive şi comerţul exterior: Teoria protecţionismului şi a schimbului internaţional, (Theory of Protectionism), Ed. Ştiinţifică şi Enciclopedică, Bucharest, 1986, p. 110; there he conflates Fulton and Papin probably because Fulton’s ship was also vandalized during some of her cruises on the Hudson River. Some further (impassioned) detail is at “Leibniz, Papin and the steam engine.”
  3. Schumpeter, Joseph A. (1994)[1942]. Capitalism, Socialism and Democracy, London: Routledge, pp. 82-83
  4. According to Wikipedia, Schumpeter, J. A. (1949): “The historical approach to the analysis of business cycles”, in Essays: On Entrepreneurs, Innovations, Business Cycles, and the Evolution of Capitalism, New Brunswick, N.J. and London: Transaction, p. 349. As quoted in “Schumpeter and Regional Innovation,” by Esben S. Andersen’s in his chapter for Handbook of Regional Innovation and Growth., P. Cooke, ed., Elgar Publ., 2011, http://en.wikipedia.org/wiki/Creative_destruction#cite_note-19, retrieved 23 July 2012
  5. ‘Parable of the broken window” (also knows as “the broken window fallacy”) http://en.wikipedia.org/wiki/Parable_of_the_broken_window, retrieved 24 July 2012
  6. Gabriel, Trip, “With a Little Theater, Romney Uses Obama’s Words Against Him”, The New York Times, The Caucus Blog, 18 July 2012, http://thecaucus.blogs.nytimes.com/2012/07/18/with-a-little-theater-romney-uses-obamas-words-against-him/, retrieved 24 July 2012
  7. Schumpeter, Joseph A. (1982) [1911]. The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, New Brunswick, N.J. and London: Transaction, Ch. II, p. 60
  8. Georgescu-Roegen, N. (1988) “Closing Remarks: About Economic Growth: A Variation on a Theme by David Hilbert”, Economic Development and Cultural Change, Vol. 36, No. 3, Supplement: Why Does Overcrowded, Resource-Poor East Asia Succeed: Lessons for the LDCs? (Apr., 1988), University of Chicago Press, p. S297
  9. Schumpeter, Theory, p. 64
  10. Kaplan, S. et al. (2008), “Should You Bet on the Jockey or the Horse? or What are Firms? Evolution from Early Business Plan to Public Company” a presentation of Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies”, Journal of Finance, February 2009
  11. Schumpeter, Theory, p. 63-64.
  12. See, for instance, Jensen, M. (1986), “Agency Costs of Free Cash Flow,Corporate Finance, and Takeovers”, The American Economic Review, Vol. 76, No. 2, May 1986, pp. 323-329
  13. Georgescu-Roegen N. (1992) “Nicholas Georgescu-Roegen about Himself,” in Szenberg M. (ed.) (1992) Eminent Economists: Their Life Philosophies, Cambridge University Press, pp 128-159, qtd. in Christoph Heinzel, “Schumpeter and Georgescu-Roegen on the Foundations of an Evolutionary Analysis”, April 2012, http://www.cheinzel.de/Homepage/Heinzel_SchGRonEvolAnal_1204.pdf
  14. Georgescu-Roegen, N. (1975), “Dynamic models and economic growth”, World Development, Elsevier, vol. 3(11-12), pages 765-783, p. 773
  15. Schumpeter, Theory, II.2, p. 73
  16. Cassidy, John, “The problem with ‘Mitt the Twit’: he’s a wazzock”, The New Yorker, 27 July 2012
  17. Ibid.
  18. Ibid., p. 75, emph. added.
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