Fostering economic growth through ‘creative destruction’

Anyone in favour of promoting economic growth needs to be familiar with the ideas of economist Joseph Schumpeter, who is the latest person to be featured in the Fraser Institute’s ongoing Essential Scholars series. Schumpeter was a Harvard professor who served as the first foreign president of the American Economic Association; while he died long ago, his theories are timeless and apply equally well to how we can recover from the recession. Schumpeter is perhaps best known for popularizing the term “creative destruction”—the process by which new innovations arise and subsequently cause the old way of doing things to disappear. This perennial gale, as Schumpeter called it, is not only the essential feature of a market economy, but is the main source of economic progress.

For economies to grow and prosper requires the decentralized effort of multitudes of individual entrepreneurs, in the pursuit of profit and prestige, experimenting with new combinations of productive resources. It’s this process of trial and error, with the profit and loss system providing quick feedback on the quality of these innovations, that is the engine leading to a brighter, more prosperous and wealthier future. There’s no one size fits all policy, no “right” answer to the questions or issues, rather the best route to a bright future relies on the process of decentralized experimentation driven by the incentive structure created by the intersection of consumer preferences and the opportunity costs of necessary productive resources.

New ideas that generate enough buyers purchasing the product at prices at least sufficient to generate enough revenue to cover the costs of production will earn profits—and their efforts will continue into the future. Insufficient revenue, and thus losses, result in business failure. Failures can also be the result of inefficiently high costs. A business that might be profitable in a low-cost location, for example, may not be profitable if it locates in the area of town with the highest rental rates for space. Thus, which resources are brought to bear in the combination is of equal importance to the value of what is produced.

There’s no crystal ball in this process. No wise man or central planner who can know which ideas are good in advance, which ways forward are best, or which resources are best suited to satisfy which needs. Uncertainty, knowledge limitations and constantly changing market conditions make this impossible. Instead it’s the profit and loss system that informs and guides this process of discovery.

Schumpeter’s view of entrepreneurship as a disruptive process of creative destruction stands in contrast to many other economists’ views of entrepreneurship as a stabilizing force in an economy where the role of entrepreneurs is to close gaps that exist in markets and bring them closer to equilibrium.

The three keys to fostering entrepreneurship, innovation and the prosperity that accompanies them are simple.

First, work to make sure society views individual entrepreneurs as the heroes they really are—quit villainizing wealth, successful entrepreneurs and business people. Aspiring to be a successful entrepreneur should be as worthwhile of a dream (if not more) for a child as being a doctor, engineer, or a political leader.

Second, ensure markets are contestable—avoid or remove government-erected barriers that protect incumbent firms from the entry of new competitors (licensing, certificate of need laws, etc.).

Third, let the profit and loss system work—don’t subsidize failing firms and don’t play favorites or subsidize industries with political pull.

As more and more people focus on the badly needed economic recovery, the ideas of Joseph Schumpeter and particularly his work on entrepreneurship and innovation should be front and centre.