37538446 Schumpeter s Business Cycles

Business History Review

80 (Summer 2006): 231261. 2006 by The Pres-ident and Fellows of Harvard College.

Thomas K. McCraw

Schumpeters

Business Cycles

as Business History

Business Cycles

was Joseph Schumpeters least successful book,measured by its professed aims and several other yardsticks.Yet the book has two vital aspects that have largely been over-looked. First, the prodigious research that went into its writ-ing caused a significant change in Schumpeters thinking aboutcapitalism. It moved him to a more historical and empiricalapproach that shaped nearly all his subsequent work. Andsecond, much of the book constitutes a preview of modern,rigorous business history. This article explores both of theseelementsnot in the spirit of rescuing a neglected classic,because the book is not a classic. Instead,

Business Cycles

is anoble failure that paid unexpected dividends both to the authorand to scholarship.

THOMAS K. MCCRAW is the Isidor Straus Professor of Business History at HarvardBusiness School.

The author thanks Kevin Burke and Felice Whittum for research assistance; Rawi Ab-delal, Jim Baughman, Jack High, and four anonymous referees for helpful advice; and SusanMcCraw for dozens of suggestions about organization, content, and presentation.

1

The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Inter-est, and the Business Cycle

(1911; translation into English by Redvers Opie, Cambridge,Mass., 1934).

I

n 1939, Schumpeter published his two-volume, 1,095-page tome,

Business Cycles

, after more than seven years of concentrated re-search. He was fifty-six years old at the time and had been a professorat Harvard since 1932. He was well known throughout the world, hav-ing published scores of articles, over seventy book reviews, and threebooks, including the brilliant

Theory of Economic Development

(1911;English translation, 1934).

1

Schumpeter struggled mightily with the research and writing of

Busi-ness Cycles.

As he told his friend and fellow cycle theorist Wesley ClairMitchell in 1937, In order to carry out so detailed an investigation aswould be necessary I would have to have a whole research staff working

Thomas K. McCraw / 232

for me. To another friend, he wrote, I am still a slave to my manu-script and for instance . . . worried last night till 2

A

.

M

., on such ques-tions as whether potatoes were important enough in Germany in 1790to count in the business cycle.

2

Even as he wrote the book, he pursued many other activities. As theundisputed star of the Economics Department, he entertained a streamof visiting scholars, led several faculty discussion groups, spent prodi-gal amounts of time counseling graduates and undergraduates, andtaught a heavy load of courses. He also devoted considerable energy toa second big projecta book on moneybut decided to defer (and ulti-mately to abandon) that effort. By the time he neared completion of

Business Cycles

, he was in a state of perfect exhaustion, as he wrote inJune 1937. Early in 1938, he reported to Harold Burbank, chairman ofthe Economics Department, I am half dead and certainly entirely dazed

Schumpeter at work in his office at Harvard shortly after Business Cycles was written.(Source: HUD 343.04, the 1943 Harvard [Class] Album, p. 43. Harvard University Archives.)

2

Business Cycles: A Theoretical, Historical, and Statistical Analysis of the CapitalistProcess

(New York, 1939). Schumpeter to Mitchell, 6 May 1937; Schumpeter to Oscar Lange,24 Feb. 1937, both in

Joseph A. Schumpeter: Briefe

/

Letters

, eds. Ulrich Hedtke and RichardSwedberg (Tbingen, 2000) (hereafter cited as

Briefe

), 295, 301, 303.

Schumpeters

Business Cycles

as Business History / 233

from the long hours I must spend on rereading and touching up mymanuscript.

3

Today, research efforts comparable to what Schumpeter was trying todo often employ teams of half a dozen statisticians, economists, and othersocial scientists. But in the 1920s and 1930s, this model of academic re-search was just getting started, and Schumpeter worked almost entirelyon his own. As his student James Tobin recalled, He didnt recruit stu-dents to help him; he didnt suggest topics arising in his own research tostudents for papers or dissertations; he didnt try out the ideas or findingsof his draft chapters in seminars. That so enormous an achievement wasthe product of lonely research tells what a great scholar Schumpeter was.

4

The design of

Business Cycles

a three-country study of the UnitedStates, Britain, and Germany, covering the whole capitalist epochwassimply too big for Schumpeter or any other scholar to handle alone. Buthis attempt to do it changed his thinking in a profound way. He adopteda much more empirical and historical approach to economics, which in-formed both

Business Cycles

and his subsequent work. The change isquite clear in

Capitalism, Socialism and Democracy

(1942), one of theseminal nonfiction works of the twentieth century.

5

3

Committee on Research in the Social Sciences, Directors correspondence, letter, Schum-peter to Committee (16 June 1937), in box 4 (PZ), UAV 737.18, Harvard University Archives.Department of Economics, correspondence and records, 193061, letter, Schumpeter toBurbank (17 Jan. 1938), in box Robertson-Schumpeter, UAV 349.11, Harvard UniversityArchives.

4

James Tobin, foreword to Eduard Mrz,

Schumpeter: Scholar, Teacher, Politician

(NewHaven, 1991), ix. Most reviews of

Business Cycles

were favorable. See E. Rothbarth of Cam-bridge,

Economic Journal

52 (JuneSept. 1942): 22329; J. Marschak of the New School,

Journal of Political Economy

48 (Dec. 1940): 88994; and Oscar Lange of the University ofChicago,

Review of Economic Statistics

23 (Nov. 1941): 19093. Hans Neisser of the Univer-sity of Pennsylvania noted several problems with Schumpeters argument, but conceded thatit will always be a marvel that such a book could be written by one man. Hans Rosenberg ofBrooklyn College wrote, This work cannot be merely read; it must be studied. Neisser,

An-nals of the American Academy

208 (March 1940): 2056; Rosenberg,

American HistoricalReview

46 (Oct. 1940): 9699.Simon Kuznets, a business-cycle theorist, pioneering macroeconomist, and future No-

bel Laureate then based at the Wharton School, wrote the longest and most important cri-tique. He praised Schumpeter for having written a monumental treatise that raised all theright questions, but he argued that cycles are quantitative phenomena, and instead of robustnumbers Schumpeter had presented an intellectual diary. He had told of his journeythrough the realm of business cycles and capitalist evolution, disclosing his encountersthere with numerous hypotheses, diverse historical facts, and statistical experiments. Theseefforts were praiseworthy, but they could not substitute for tight quantitative analysis. SeeKuznets,

American Economic Review

30 (June 1940): 257, 26671. A response came fromNicholas Mirkowich of the University of California, who pointed out that the book is not aboutcycles alone, but is a more general theory of economic development, extending the work Schum-peter had begun in his first two books; and contending that readers should not throw out thebaby with the bathwater. See Mirkowich,

American Economic Review

30 (Sept. 1940): 580.

5

Including

Business Cycles

, Schumpeters published work for the remainder of his careertotals about two million words. Of this work, Nathan Rosenberg has argued, The fact is thatmost of what Schumpeter wrote qualifies as history, both economic and intellectual. . . . More


The Main Goal of the 1939 Book

Schumpeter chose the title

Business Cycles

not only because thetopic was then fashionable (it was the central economic puzzle of thetime, and had been even before the Great Depression), but also becausehe wanted to emphasize the economic ebb and flow that defines capi-talism. Cycles, he writes in his preface, are not, like tonsils, separablethings that might be treated by themselves, but are, like the beat of theheart, of the essence of the organism that displays them.

6

This may be true enough, but here Schumpeter extends the themeof cycles into something like a determinate paradigm. He attempts thehopeless task of fitting historical patterns of business booms and bustsinto predictable wave periods of standard lengths. Barring very fewcases in which difficulties arise, he writes, it is possible to count off,historically as well as statistically, six Juglars [eight- to ten-year cycles]to a Kondratieff [fifty to sixty years] and three Kitchins [forty months]to a Juglarnot as an average but in every individual case.

7

Clement Juglar, Joseph Kitchin, and Nikolai Kondratieff wereprominent business-cycle theorists. References to their work appearhundreds of times in the text of Schumpeters book, and make it ex-tremely difficult to read. Here is a representative sentence: Both crises[the downturns of 1826 and 1836] occurred when, taking the Juglarand the Kondratieff phase together, we should be prepared to findmajor dips in prices and values: a Juglar recession on a Kondratieff de-pression forms the background of the one, and a Juglar depression on a

than this, the very subject matter of economics, in Schumpeters view, is history. Rosenberg,Joseph Schumpeter: Radical Economist, in Yuichi Shionoya and Mark Perlman, eds.,

Schum-peter in the History of Ideas

(Ann Arbor, Mich., 1994), 56. In his book

Schumpeter and theEndogeneity of Technology: Some American Perspectives

(New York, 2000), Rosenbergmakes a thorough case that Schumpeter was fundamentally an economic historian.

6

Business Cycles

, vol. 1, v. This was by no means the first time Schumpeter had madesuch an argument. See Schumpeter, ber das Wesen der Wirtschaftskrisen,

Zeitschrift frVolkswirtschaft, Socialpolitik und Verwaltung

19 (1910): 271325; and Harald Hagemann,Schumpeters Early Contributions on Crises Theory and Business-Cycle Theory,

History ofEconomic Ideas

11 (2003): 4767.

7

Business Cycles

, vol. 1, 169, 17374. Schumpeter would likely have been better advisedto focus on the basic Juglar cycle, which for his purposes was the most plausible and impor-tant of the three. At times in the book he wrote not just of three cycles but of five, and in factthere could be many more than that, as innumerable stock-market analysts have tried toshow. But the overall point was the one he made in his preface: cycles are of the essence incapitalism; and it follows that depressions are an inescapable and even beneficial phase in itsevolution. In a letter to the prominent American scholar Paul Homan, Schumpeter elabo-rated a bit: For if one thinks of business cycles as the typical form of capitalistic evolutionand if one looks upon those long time movements, which are sometimes called industrial rev-olutions, as one species of business cycles, it is but natural to link up with the cyclical phe-nomenon practically the whole of the economics and sociology of capitalist society. Schum-peter to Homan, 2 Apr. 1938, in Hedtke and Swedberg, eds.,

Briefe

, 309.

Schumpeters

Business Cycles


Kondratieff revival, the background of the other. Schumpeters stu-dent Paul Samuelson later commented that the books arguments beganto smack of Pythagorean moonshine.

8

Schumpeter himself had ambivalent feelings about his framework.As he told Wesley Clair Mitchell, I must repeat again, lest misunder-standing arise, that I file no theoretical claims for the three-cycle scheme.It is primarily a descriptive device which I have found useful. In thetext of

Business Cycles

, he admits that it is indeed difficult to see whyboom-and-bust patterns might occur at such determinate intervals. In-deed it is, and Schumpeters own stance is guarded and empirically in-formed. As he said to Mitchell, Any such diagnosis stands and fallswith the historical evidence on which it rests. Theory is indispensableto understanding business cycles and capitalism itself. But detailed his-torical analysis is no less so.

9

Schumpeters Rhetoricand Keyness

Schumpeter could be a very persuasive writer, but in

BusinessCycles

he appears at his stylistic worst. Read cover to cover (a chore Ido not recommend), the book conveys the impression of an author try-ing to squeeze a profusion of diverse topics into a single work, all in ser-vice to an untenable thesis. Schumpeter had grown up reading ponder-ous German treatises containing sentences hundreds of words long,and his verbosity in

Business Cycles

contrasts with the tight prose thatmarks the work of his fellow economist John Maynard Keynes. Thebook that made Keynes famous,

The Economic Consequences of thePeace

(1920), is an easy read, a model of concision and argument. Key-ness

General Theory of Employment, Interest, and Money

(1936) ismuch more technical and difficult, but no less a rhetorical tour de force.

8

Business Cycles

, vol. 1, 299; Samuelson, Joseph A. Schumpeter,

Dictionary of Ameri-can Biography

, suppl.4, 19461950 (New York, 1974), 723. This is not to say that the three-cycle scheme has no value at all. See, for example, Allen Oakley,

Schumpeters Theory ofCapitalist Motion: A Critical Exposition and Reassessment

(Aldershot, U.K., 1990); Christo-pher Freeman, Schumpeters

Business Cycles

Revisited, in Arnold Heertje and Mark Perl-man, eds.,

Evolving Technology and Market Structure: Studies in Schumpeterian Eco-nomics

(Ann Arbor, 1990), 1738; Maria Brouwer,

Schumpeterian Puzzles: TechnologicalCompetition and Economic Evolution

(New York, 1991), esp. ch. 1; and Mmtaz Keklik,

Schumpeter, Innovation and Growth: Long-cycle Dynamics in the PostWWII AmericanManufacturing Industries

(Aldershot, U.K., 2003).

9

Business Cycles

, 174, 224. If, for example, a war or natural calamity interrupted a pe-riods prosperity, Schumpeter still counted that period as prosperous in his cyclical schema.Otherwise, he wrote, it would be inadmissible for a doctor to say: Organically this man isperfectly sound. If he is dying that is due to a brick which has fallen on his head. I stronglyfeel that we must get thoroughly rid of the prejudice that our [cyclical] phenomena are simpleand can be directly handled by simple methods either theoretical or statistical. Schumpeterto Mitchell, 6 May 1937, in Hedtke and Swedberg, eds.,

Briefe

, 301, 303.


In neither book does Keynes stray from his main subject. He writeswith total self-assurance. He concedes nothing to the opposition. Withconsummate skill, he sweeps readers along to the conclusions he wantsthem to reach, even though his evidence is sometimes weak.

10

None of this was accidental. During the years when Keynes waswriting

The General Theory

, he tried out his ideas again and againwithin his elite circle of young economists at Cambridge University. Heincorporated their many insights, particularly those of Richard Kahn,whose multiplier effect became crucial to Keyness thesis. Meanwhile,Keynes discarded some of his own wrong-headed arguments and excessverbiage.

11

Schumpeter, working almost alone, seldom exposed his work-in-progress to anyone. He badly needed what Keynes hada peer groupthat would tell him, No, this wont quite do. But he did nothing to as-semble such a group. Any number of his colleagues and studentsWassily Leontief, Paul Samuelson, James Tobin (each a future NobelPrize-winner), Gottfried Haberler, Paul Sweezy, Elizabeth Boodycouldhave helped. But Schumpeter never asked them. Instead, he plungedahead, putting far too many words on paper and publishing reams ofuntested ideas and unedited copy.

12

In his review of Keyness

General Theory

, Schumpeter reproachesthe author for calling his theory general when it actually applies to aspecial situation. Worse, under the guise of a purely theoretical discus-sion, Keyness logic moves from the policy he favors to a theory thatwill support it, a sequence abhorrent to Schumpeter. Throughout

TheGeneral Theory

, Keynes pleads for a definite policy, and on every pagethe ghost of that policy looks over the shoulder of the analyst, frameshis assumptions, guides his pen. Overall, says Schumpeter, the capi-talist process is essentially a process of change of the type which is being

10

Schumpeter sent Keynes a copy of

Business Cycles

, and received a cordial reply. Hethen wrote in a letter to Keynes, I cannot visualize you really wading through those twovolsor else I should apologize, not only for my egotistical concentration on my own tale(which you so generously forgive) but also that terrible size due to my wish to deal fully, his-torically and statistically, with 16 units of what I call the Juglar cycle, pointing laboriouslyin every instance to where my schema fits the facts and where it doesnt. Schumpeter toKeynes, 3 Oct. 1939, in Hedtke and Swedberg, eds.,

Briefe

, 31920.

11

On the composition, publication, and reception of

The General Theory

, see RobertSkidelsky,

John Maynard Keynes: The Economist as Savior, 19201937

(New York, 1992),chs. 1416.

12

In the acknowledgments to

Business Cycles

, Schumpeter thanks a few research assis-tants and, briefly, two of his Harvard colleagues, Seymour Harris and W. L. Crum, as well asProfessor Gordon, now of the University of California, and Dr. Clausing of the Universityof Bonn, but not the many other friends and colleagues who could have given him usefuladvicenot even his wife Elizabeth Boody Schumpeter, herself a very capable economist(vol. 1, pp. viiviii).

Schumpeters

Business Cycles


assumed away in this book. In Keynesian and other macroeconomicmodels, individual entrepreneurs, companies, and industries vanish fromthe scene. In complete contrast to Schumpeters approach in

BusinessCycles

, no mention of a single business firm occurs over the 403-pagelength of

The General Theory.

13

Yet what appealed to readers of

The General Theory

was the veryaspect that offended Schumpeter: a plausible diagnosis of the Great De-pression, and a prescription for its cure. However legitimate Schum-peters protests may have beenand a flood of scholarship over thenext four decades washed away substantial parts of Keyness argumentmost people at the time cared far more about finding a way out of thedepression. Keynes provided a good road map, and that was a contribu-tion of incalculable value. Conversely, Schumpeters own refusal to pre-scribe remedies vastly reduced the appeal of

Business Cycles.

I recom-mend no policy and propose no plan, he writes. Instead, his book canbe used to derive practical conclusions of the most conservative as wellas the most radical complexion.

14

With his typical intellectual curiosity, Schumpeter strays in

Busi-ness Cycles

onto whatever tangents interest him. And, in line with hisfrequent tributes to science, he gives ample space to dissenting opin-ions. If this made his book more difficult and less persuasive, then so beit. Striking an almost defiant tone, Schumpeter says in his preface, Thereader will find the structure of the argument complex. To his justifi-able groan I have nothing to oppose but the question whether he ex-pected to find it easy. But however much an authors reach should exceedhis grasp, it is not by this much.

15

His method of writing resembles that of the American novelistThomas Wolfe, another untamed genius who was turning out mam-moth manuscripts at about the same time. Wolfes fertile brain, likeSchumpeters, teemed with stream-of-consciousness associations thathe scribbled down in the heat of composition. But unlike Schumpeter,

13

Schumpeter, review of

The General Theory of Employment, Interest and Money

, in

Journal of the American Statistical Association 31 (Dec. 1936): 79495. In The General The-ory, Keynes names dozens of economists and describes their ideas in detailoften very criti-cal detail. He takes no note of Schumpeter, and little of other European business-cycle theo-rists. Keynes did not read German easily, and he paid insufficient homage to the giants ofeither the German tradition of economics or the Austrian: to the Germans Gustav Schmoller,Werner Sombart, Max Weber, Arthur Spiethoff, and Adolph Lwe; to the Austrians CarlMenger, Friedrich von Wieser, Eugen von Bhm-Bawerk, Ludwig von Mises, and Friedrichvon Hayek. Many distinguished economists besides Schumpeter wrote negative reviews ofThe General Theory, among them Frank Knight, Jacob Viner, A. C. Pigou, Dennis Robertson,and Alvin Hansen, who later changed his mind and became an ardent supporter of Keynes.

14 Business Cycles, vol. 1, vi. Schumpeter goes on to say that he wishes to make it clearthat my analysis lends no support to any general principle of laisser faire.

15 Ibid., vvi.


Wolfe had a marvelous editorMaxwell Perkins of Scribners, who re-organized Wolfes great novel Look Homeward, Angel and cut its lengthby almost one-third. Had an editor of Perkinss talents applied his skillsto Business Cycles, the book might well have fulfilledand exceededSchumpeters ambitions.16

The reorganized work would likely have appeared not as one bookbut as three. The first editorial step would have been to strip the three-cycle scheme from the text and publish it separately as provocative hy-potheses about business booms and busts. A second book would havedrawn off about 250 of the 309 pages in Business Cycles devoted to the1920s and 1930s and presented that material as an account of recenteconomic trends.17

The third book would have consolidated and elaborated the splen-did passages on the long-term evolution of business in the way I willdelineate in the next sections of this article. In that form, the bookwould have been a successful marriage of history and theory, and po-tentially a masterpiece. Among other contributions, it would have sig-naled the birth of truly rigorous business history. Schumpeter had avery strong attraction to history, and after writing Business Cycles, heurged again and again that economists pay more attention to it.18

16 Perkins also edited most of the work of F. Scott Fitzgerald and Ernest Hemingway. Inaddition to condensing Look Homeward, Angel, he cut Wolfes Of Time and the River byabout half. See David Herbert Donald, Look Homeward: A Life of Thomas Wolfe (New York,1987), 202, 294303; and the long discussion on pp. 46484 of the controversial work ofanother editor, Edward Aswell, on Wolfes posthumously published novels.

17 In 1964, the economist Rendigs Fels of Vanderbilt, a former student of Schumpeters,condensed Business Cycles by about 50 percent, though not in the pattern I have describedhere. McGraw-Hill, the original publisher, brought out this abridged edition. It was not verysuccessful.

18 See, for example, The Creative Response in Economic History, Journal of EconomicHistory 7 (Nov. 1947): 14959; The Historical Approach to the Analysis of Business Cycles,in UniversitiesNational Bureau Conference on Business Cycle Research, Conference on Busi-ness Cycles (New York, 1949), 14962; Economic Theory and Entrepreneurial History, inChange and the Entrepreneur (Cambridge, Mass., 1949): 6384; and History of EconomicAnalysis (New York, 1954).

One of the most significant early signs of Schumpeters movement toward a greater ap-preciation of history (and sociology) was his appreciative reconsideration of the leader of theGerman Historical School. See Schumpeter, Gustav v. Schmoller und die Probleme vonheute, Schmollers Jahrbuch fr Gesetzgebung, Verwaltung und Volkswirtschaft imDeustchen Reich 50 (1926), vol. 1, 33788. For a discussion of the importance of this piece,see Richard Swedberg, Schumpeter: A Biography (Princeton, N.J., 1991), 8289. On thewhole, however, Schumpeters turn toward history as represented in Business Cycles doesnot signal a revival of the German Historical School. As is well known, Carl Menger and otherleaders of the heavily theoretical Austrian School in which Schumpeter had trained at theUniversity of Vienna engaged in a long and bitter Methodenstreit (struggle over methods)with the German Historical School. Schumpeter lamented the Methodenstreit and respectedthe Historical School; but he regarded it, on the whole, as handicapped in constructing thekinds of comparative histories that would inform theory.

Schumpeters Business Cycles as Business History / 239

The Model Outlined

The historical core of Business Cycles is its analysis of the flower-ing of business systems in Britain, Germany, and especially the UnitedStates. Schumpeter focuses on five industries that led the process of eco-nomic development: cotton textiles, railroads, steel, automobiles, andelectric power. He also emphasizes three institutional innovations cru-cial to the rise of capitalism: the factory, the corporation, and the mod-ern financial system. In order to convey the unusually full range of hisanalysis, I will have to summarize his presentation at greater lengththan I would like. Here and thereprincipally in footnotesI will brieflyamplify his argument in the light of subsequent research.

Schumpeter begins by setting forth a general theory of capitalistevolution. In his model, recurring Innovation propels the economy,which exists in a state of constant tumult. The New Men, or Entrepre-neurs, operating within New Firms, drive Innovation. (Like many otherwriters of the time, Schumpeter capitalizes some of his key terms.) Allcompanies react adaptively to change, but creative responses comeonly from innovative acts by Entrepreneurs. Innovation can take manyforms. As examples, Schumpeter mentions the case of a new commod-ity, a new form of organization such as a merger, and the openingup of new markets. Innovating firms do not arise evenly throughoutthe economy. Instead, groups of innovators emerge during periods justafter an organizational or technological breakthrough in a particularindustryeither in that same industry or in others allied to it.19

Meanwhile, powerful elements of society resist all major innova-tions, because they wreak havoc on existing arrangements. As a result,the history of capitalism is studded with violent bursts and catastrophes.The building of a railroad where none had existed, for example, upsetsall conditions of location, all cost calculations, all production functionswithin its radius of influence. Innovation, then, is a very much a two-edged sword.20

Schumpeter next turns his attention to the key figure of the system,the Entrepreneur (or New Man), and to the Entrepreneurs necessarycompanion, Profit. He concedes that in some situations it is hard toidentify the Entrepreneur. In the real world of business, nobody ever isan entrepreneur all the time, and nobody can ever be only an entrepre-

19 Business Cycles, vol. 1, 7273, 84102. Here Schumpeter recurs to his categorization ofinnovation first set forth in The Theory of Economic Development (1911). He also anticipateshis article, The Creative Response in Economic History, which had a significant impact onbusiness historians.

20 Business Cycles, vol. 1, 1002.


neur. Particularly in large firms, the Entrepreneur often not only inno-vates but also carries out day-to-day management.21

Of all economic systems, capitalism best enables people to createventures before they possess the necessary funds and other resourcesto found an enterprise. For any given innovation, the Entrepreneurmay, but need not, be the person who furnishes the capital. In theend, it is leadership rather than ownership that matters. The failureof both the classical economists and Karl Marx to visualize clearly en-trepreneurial activity as a distinct function sui generisa distinctionSchumpeter always underscoredwas a crucial flaw in their analysis ofcapitalism.22

The prior possession of money makes it easier to become an entre-preneur, of course, and successful ones do usually become wealthy. Butthe historical record shows unmistakably that, in the countries Schum-peter is discussing, entrepreneurs come from all income groups. (Hehad a deep interest in social classes, a topic he often wrote about.) Riskbearing is no part of the entrepreneurial function. It is the capitalistwho bears the risk. The entrepreneur does so only to the extent towhich . . . he is also capitalist, but qua entrepreneur he loses otherpeoples money.23

Having staked out the distinctive role of the Entrepreneur, Schum-peter identifies entrepreneurial Profit as the prime motivatorthepremium put upon successful innovation. When other participants inthe same industry see the new level of Profit, they try to duplicate theInnovation. In turn, the Entrepreneur tries to preserve his high Profitfor as long as possiblethrough further innovation, the use of patents,secret processes, advertising, and aggression directed against actualand would-be competitors. These are forms of what, three years later,Schumpeter famously called creative destruction in Capitalism, So-cialism and Democracy.24

Thus, a New Firms intrusion into an existing industry always entailswarring with an old sphere, which tries to prohibit, discredit, or other-wise restrict the advantage afforded to the New Firm by its innovation.

21 Ibid., 102, 103. Schumpeter adds, The outlines of an economic and sociological analysisof both types and both functions appear in The Theory of Economic Development, chs. 2and 4.

22 Business Cycles, vol. 1, 1034.23 Ibid., 104. Among many examples of his preoccupation with class, see Schumpeter,

Die Tendenzen unserer sozialen Struktur, Die Chemische Industrie, 51/52 (24 Dec. 1928),reprinted in Schumpeter, Aufstze zur Tagespolitik, eds. Christian Seidl and Wolfgang F.Stolper (Tbingen, 1993), 17793; and Social Classes in an Ethnically Homogeneous Envi-ronment, originally published in 1927, reprinted in Imperialism, Social Classes: Two Essaysby Joseph Schumpeter (New York, 1955), transl. by Heinz Norden, intro. by Bert Hoselitz.



But every entrepreneurs high profit is temporary, as competitors copythe innovation and prices fall. This sequence of cutting prices, whichSchumpeter calls competing down, occurs in all industries exceptthose protected by government monopoly. Competing down may takeseveral years and is often hard for contemporaries to see. But the under-lying point is a transcendent one, and it is why Schumpeter seldomworried about monopolies other than those sponsored by governments.25

The Model Elaborated

History is philosophy learned from examples, Thucydides wrotein about 420 BC, and Schumpeter deluges the reader with examplesfrom business history. In the interest of concision, I will here devotemore space to three of the industries Schumpeter covers (textiles, rail-roads, and electricity) than to steel and automobiles; more to two of hisinstitutional innovations (factories and finance) than to corporations;and, as Schumpeter himself does, more to the United States and Britainthan to Germany.

He begins with the origins of the factory system in England, thefirst large nation to industrialize. In the late 1500s, he writes, a few En-glish entrepreneurs systematically cut their production costs so thatthey could reduce their selling prices. Lower prices stimulated demandand enabled producers to manufacture in larger volume and to sell acrosswider areas. Over the long term, the new factory system flourished be-yond the dreams of its proponents. It gathered large numbers of workersinto one place, set uniform standards for quality, and divided produc-tion into separate steps performed by specialized workersall underthe discipline of the clock.26

Schumpeter was careful to point out that the factory system intro-duced more efficient production even into old industries, such as tex-tiles. The shift from home spinning and weaving to mechanized pro-duction of cloth was so profound that it launched the first industrialrevolution. Consumers demand for affordable factory-made cotton clothturned out to be immense.27

25 Ibid., 1058, 291.26 Ibid., 24041. Schumpeter does not give it sufficient emphasis, but the use of the clock

was a vital innovation in the industrial revolution. Rather than using sun time and toilingsporadically at home, workers gathered in one place and labored together under a rigidschedule. Outside the factory, the clock changed the way people thought about life in general.See David S. Landes, Revolution in Time: Clocks and the Making of the Modern World (Cam-bridge, Mass., 1983).

27 Business Cycles, vol. 1, 242. For elaborations of the advantages of cotton over wool, seeDavid S. Landes, The Wealth and Poverty of Nations (New York, 2001).


The factory system modernized many other existing industries aswell. In iron and steel, bigger furnaces facilitated production on a largescale of standardized intermediate goods, such as ingots, sheets, rods,and wire. Factories increased the output of a wide range of products:metalwork made of copper and brass, paper made in mills driven bywater wheels, potteries, sugar refineries . . . glass, soap, and gunpowderfactories, and salt-boiling establishments. Factories triggered a newera in English economic life, raising the overall standard of living andbringing huge fortunes for individual entrepreneurs.28

But the shift did not come easily. A major theme of Business Cyclesis the extreme difficulty of changing traditional ways of doing things.More than most analysts, Schumpeter emphasized that the destructivepart of creative destruction has always been quite real, and he stressedthat those whose interests are being destroyed will fight hard to pre-serve their culture and status. In England and elsewhere, small-scalecraftsmen and their guilds had esteemed artistry, community, and tra-dition over other benefits, such as low prices, increased output, and ex-panded exports. These predilections went back for centuries, and the onlyway to change them was through overwhelming economic defeat.29

Entrenched interests fought tenaciously against mechanization andthe factory system. Unlike the Prussian inventor of a ribbon-weavingloom who was put to death in 1579 by order of the Danzig municipal au-thority, entrepreneurs were not necessarily strangled, but they werenot infrequently in danger of their lives. Craft guilds in England in-voked medieval laws to prevent both outsiders and their own membersfrom using innovative methods. They petitioned for regulations outlaw-ing factories and particular mechanical devices. Schumpeter cites theWeavers Act of 1555 and a Royal proclamation which in 1624 directedthat a new machine for the manufacture of needles be destroyed. Andregardless of what the law might allow at a particular time, craftsmenthemselves simply smashed the new machines, again and again.30

In response, English entrepreneurs often moved their factoriesaway from guild-dominated towns. Operating in the countryside, theycould proceed without the fetters of official repression and with the ad-vantage of cheaper labor, although, even in the new outposts, the inno-vators had to fix things with local authorities. Yet, whatever the ob-stacles, in certain industries they were almost sure to win in the longterm. Large-scale factory production offered more jobs for workers,cheaper goods for consumers, a richer tax base for governments, and adominant foreign-trade position for England. In London, the political

28 Business Cycles, vol. 1, 242.29 Ibid., 24043.30 Ibid., 243, 244.


world wavered in its attitude and motivation. Soon, however, businessitself became a major force in politics, and by the eighteenth centuryParliament had largely caved in.31

Besides innovating in production, entrepreneurs often had to changehabits of consumption. Confronted with growing inventories, industri-alists had to convince reluctant customers that they actually needed thenew goods. Here Schumpeter, unlike most economists, places heavyemphasis on the role of marketing in mass consumption, and in eco-nomic growth itself. It was not enough to produce satisfactory soap,he writes; it was also necessary to induce people to washa socialfunction of advertisement that is often inadequately appreciated.32

From the perspective of producers and investors, it did not matterwhether new wants were real necessities. Needs, Schumpeter observes,whatever they may be, are never more than conditioning factors, andin many cases mere products of entrepreneurial action. Undeniableneeds such as food, clothing, and shelter do not, by themselves, set thecapitalist engine into motion. This is why economic development(capitalist consumption included) has never been conspicuous in thecountries which to the observer seem to be most lavishly supplied withneeds. Therefore, in order to understand the anatomy of capitalism,analysts are best advised to study industries in economically advancedcountries, not in the underdeveloped world. And in Business Cycles,Schumpeter gives scores of illustrations from Britain, Germany, andthe United States.33

Textiles. His first example, cotton textiles, dated from the MiddleAges in Germany and Switzerland and, a little later, in India. But thekey change occurred in Britain, when the East India Company began toimport cotton cloth. As usual, the change met fierce resistance. In 1721,old firms in woolens and silks secured, with due reference to the inter-est of the English workman, a prohibition of the sale as well as thewearing of printed, painted, or dyed calicoes.34

31 Ibid., 240, 241, 244.32 Schumpeter, ibid., 243. In The Theory of Economic Development (p. 65), Schumpeter

had written that companies had to teach consumers to want new things.33 Business Cycles, vol. 2, 1035. On the importance of marketing, advertising, and selling

in the American economy, see Susan Strasser, Satisfaction Guaranteed: The Making of theAmerican Mass Market (New York, 1989); Richard S. Tedlow, New and Improved: TheStory of Mass Marketing in America (New York, 1990); Daniel Pope, The Making of ModernAdvertising (New York, 1983); Roland Marchand, Advertising the American Dream: Mak-ing Way for Modernity, 19201940 (Berkeley, 1985); Pamela Walker Laird, AdvertisingProgress: American Business and the Rise of Consumer Marketing (Baltimore, 1998); andWalter A. Friedman, Birth of a Salesman: The Transformation of Selling in America (Cam-bridge, Mass., 2004).

34 Business Cycles, vol. 1, 27071. The word calico is a corruption of Calcutta; and theBritish later began to suppress production in India as a means of assisting exports of clothfrom the mother country. The industry in India did not recover until the twentieth century.


At that time, a small British cotton industry provided thread asweft for linen warp in blended fabric. In 1736 the government grantedthe industry an exemption from the ban on cotton, and in so doing cre-ated a new demand for yarn. It then repealed anticotton laws altogetherin 1774, and thereafter British producers could make fabrics from cottonalone. By the 1780s, abundant innovation had set the stage for a giantleap in production. The use of cotton fabrics spread quicklyinducing,as Schumpeter puts it, improvement, dislocation and absorption,copying, following, and competing. As prices fell, the real avalancheof products came.35

Again, traditional craftsmen reacted violently. In the early years,weavers wrecked John Kays new loom that featured a so-called flyingshuttle (invented in 1733), and they drove Kay himself to France. Otherprotestors smashed many of James Hargreavess new spinning engines(jennies, patented in 1770). In 1792 still others destroyed the factorythat made Edmund Cartwrights power looms. And from 1811 to 1816,the notorious Luddites hammered textile machinery to bits.36

In describing the industrial revolutionand in probing the natureof change, which is the heart of his thesisSchumpeter draws sharpdistinctions between inventors and entrepreneurs, and between inven-tions and innovations. The making of the invention and the carryingout of the corresponding innovation are, economically and sociologi-cally, two entirely different things. Often the two interact, but theyare never the same, and innovations are usually more important thaninventions.37

The career of Richard Arkwright (173292) exemplifies these dis-tinctions especially well. Arkwright was an inventor, butmuch morecriticallyan innovating entrepreneur. Other businessmen paid himhandsome fees for the use of his patented machines, and he operatedseveral factories himself. Before long, he became very rich and receiveda knighthood. In Schumpeters terms, Arkwright was a New Man orga-nizing a New Firm and reaping a large entrepreneurial Profit.38

35 Ibid., 271.36 Ibid., 27172.37 In analyzing economic development, only confusion can result from focusing on in-

ventions instead of innovations. Ibid., 8485, 27172. Schumpeter had made this point before,as early as in The Theory of Economic Development. In later years this distinction became afoundation stone in the subdiscipline of the history of technology, as is evident in the perusalof almost any issue of the journal Technology and Culture. Two of the best books that treatthe subject (among others) are David S. Landes, The Unbound Prometheus: TechnologicalChange and Industrial Development in Europe from 1750 to the Present (Cambridge, U.K.,1969); and Joel Mokyr, The Lever of Riches: Technological Creativity and EconomicProgress (New York, 1990). Mokyrs book contains a particularly effective (and explicit)delineation of the Schumpeterian perspective on technology.



Arkwrights multiple innovations and skills in organizing a newsystem far surpassed the significance of his inventions alone. Doingthe thing, as Schumpeter calls itthe actual setting up of new pro-duction functionsis a distinct phenomenon. The falling domino ofone innovation topples the next domino, in an endless series radiatingin all directions. We readily see how every step conditions other stepsyarn and cloth, for instance, alternating in offering new demand to eachother and in running up against bottlenecks, the removal of which thenmakes the next achievement.39

After many decades of prosperity, the cotton industry drifted intotorpor. British firms had prospered so handsomely that they sawlittle incentive to innovate further. Many held to traditional mule-spinning technology, turning their backs on the vastly superior ring-spinning method. Some recoiled from the common-sense idea of hav-ing the same company spin thread and weave cloth. Toward the end ofthe nineteenth century, they began to lose ground to innovating Ameri-can and European companies. And by the time British firms did mod-ernize their factories and integrate spinning and weaving, it was toolate.40

Both the rise and decline of the British cotton textile industry fitSchumpeters argument almost perfectly. For about 150 years after thebreakthroughs of Hargreaves, Cartwright, and Arkwright, thousands offamily-owned companies specialized in only one or two steps in thelong process of production and became slow to innovate. The industrydeclined because of the presence of many small or medium-sized firmswhich were inefficient but unencumbered [with debt] and could mud-dle on indefinitely. Over the long term, the cotton textile industryBritains most importantneglected the organizational innovations soimportant in Schumpeters scheme of things. For this entrepreneurialdereliction, the industry paid a grievous price.41

In Germany, the textile industry benefited from the pioneeringventures of both Britain and the United States. Germany was not uni-fied as a nation until 1871, a century after the key innovations had been

39 Ibid. The burgeoning demand for cotton made the American Eli Whitneys gin (1793)one of the most important inventions in history. This was true in many senses, because Whit-neys breakthrough induced a tremendous expansion of slavery, which had been in decline ontobacco and rice plantations.

40 Many scholars have analyzed this process. See, for example, William Lazonick, Com-petitive Advantage on the Shop Floor (Cambridge, Mass., 1990), chs. 35, and the notes tothose chapters.

41 Business Cycles, vol. 1, 37576. As noted, an immense literature on the evolution of theBritish textile industry, and particularly cotton, developed both before and after Schumpeterwrote this analysis.


completed in Britain. It never became a world leader in textiles, as itdid in chemicals and electrical equipment. Instead, German textile en-trepreneurs contented themselves with introducing methods that hadalready been successful abroad, mechanizing by means of partly im-ported machinery, setting up new factories, [and] especially solving theproblems of the large-scale factory. The Germans were better thanthe British in organizing their textile industry, even though they con-tributed little to its mechanical technology.42

Schumpeter concludes his analysis of the world textile industry bydescribing the rise of rayon, the first synthetic fiber. This story well il-lustrates how innovation can revolutionize industries already thoughtto be mature. In rayon, the Entrepreneur was the French Count Char-donnet, who in the late nineteenth century solved the commercialand organizational as well as some additional technological problems andmade the product a success. Other innovators in France, Britain, and theUnited States quickly developed their own ways of making rayon. Even-tually, what had started as a modest effort to manufacture cheap artifi-cial silk grew to a major industry that by 1913 was producing twenty-nine million pounds of fabric annually.43

Rayon brought a new type of competition to textilesnot amongthousands of small firms, but among several large chemical companies.Demand grew very fast. Entrepreneurial profits soared in the begin-ning, and a few firms with deep pockets emerged as the leaders. In theUnited States, after a shakeout of numerous companies, three came todominate. All threeAmerican Viscose, Celanese, and Industrial Rayonwere affiliated with European firms that had pioneered in rayon butwere handicapped in selling to the American market by U.S. tariffprotection.44

42 Ibid., 357.43 Ibid., 43334.44 Ibid., 435. As it turned out, of course, rayon was only the first of a long list of synthetic

fibers that emerged from the chemical industry. The most important was nylon, developedduring the 1930s even as Schumpeter was writing Business Cycles. Afterward, there came aflood of other new synthetics, all produced either by chemical firms (especially DuPont), orby petrochemical subsidiaries of oil companies. The rise of rayon and nylon, and then of avast array of other synthetics (orlon, dacron, polyesters), completely transformed the oldtextile industry. And, in every case, identifiable entrepreneurs led the wayNew Men, but inthis case working in established science-based companies. In the latter half of the twentiethcentury, petroleum-based synthetic materials ramified through the economies of all industri-alized nations. They generated hundreds of new plastics and other products that replacednatural leather, rubber, wood, metals, paints, and adhesives. The petrochemical revolutionwas so pervasive that it invites comparison with the steam engine and the electric generator.It not only created disturbances in a group of industries but it also cut wide swaths throughentire economies. In the large literature on this subject, see especially David A. Hounshelland John Kenly Smith, Science and Corporate Strategy: Du Pont R & D, 19021980 (Cam-


Railroads and Finance. Schumpeters favorite example of Innova-tion by New Men and New Firms was the American railroad industry. Inthe 1830s, entrepreneurs started a few rail lines as a means of movinginland raw materials to seaports. A little later, as steam engines becamemore efficient and coal mines were better developed, railroads largelydisplaced canal and turnpike systems. The Railroadization of theUnited States, as Schumpeter calls it, was an unprecedented engineeringachievement, and a milestone in the development of both the Americanbusiness system and the nation itself.45

By the 1890s, an immense railway network linked every region ofthe United States with every other region. With such cheap and fasttransportation, a unified domestic market arose for an unprecedentedvariety of industrial products and consumer goods. Manufacturers, whole-salers, and retailers could now ship and receive goods very quickly. As-sisted by the telegraph, they could communicate with each other in sec-onds and minutes.46

Meanwhile, the multitude of construction programs undertaken byrailroads stimulated a host of other industries: coal, iron, steel, ma-chinery, and petroleum-based lubricants and fuel. Across the conti-nent, railroads created new communities of all sizes. Chicago was achild of the railroads, as were Omaha, Fort Worth, Denver, and thou-sands of smaller towns. Even established manufacturing cities, such asPittsburgh, once more mushroomed. The new Pittsburgh arose on thebacks of the Pennsylvania Railroad, Carnegie Steel, Heinz Foods, andother major companies that depended on rail transportation.47

As with almost all innovations, opponents fought desperatelyagainst the development of rail networks. In addition to using legal ob-stacles (blocking the purchase of large corridors of land for railroadtracks), established interests threw up every other barrier they couldthink of. Canal companies, for example, demanded bribes in the formof side payments as the price of their surrender. But, as Schumpetergoes on to say, railroads had so many advantages that they simply over-whelmed traditional modes of transportation.48

bridge, U.K., 1988); Peter H. Spitz, Petrochemicals: The Rise of an Industry (New York,1988); and Alfred D. Chandler Jr., Shaping the Industrial Century: The Remarkable Storyof the Evolution of the Modern Chemical and Pharmaceutical Industries (Cambridge, Mass.,2005).

45 Business Cycles, vol. 1, 28992, 325, 383. Schumpeter does not, of course, explore thefull social history of American railroads.

46 Ibid., 327. Schumpeter mentions the telegraph elsewhere in the book, but gives too littleattention to it.

47 Ibid., 38388. Schumpeter does not mention all the cities, nor all the companies, listedhere.

48 Ibid., 291.


Soon the competing-down element hit the railroad industry it-self, from within. Under intense pressure from competing railways, ex-isting companies slashed their freight and passenger rates, sometimesto levels below their own costs. Construction slowed, few new firms ap-peared, and the industry went through a violent shakeout that featuredmergers, refinancings, and the loss of large individual fortunes.

Railroading then became part of the general business organism,as Schumpeter calls it, characterized by mutual dependence all around.This was typical of capitalist evolution. The more an innovation be-comes established, the more it loses the character of an innovation andthe more it begins to follow impulses, instead of giving them. Railroadmergers and refinancings occurred by way of spectacular strugglesbetween controlling groups. The shakeout appeared to the general pub-lic in the form of freight wars, cutthroat competition, discrimination,and the evils of unregulated enterprise. There were indeed plenty ofscandals, but the real story was one of consolidation, efficient admin-istration, and sound finance, thus ushering in the last step of Americasrailroadization.49

Because railroads cost colossal sums and took months or years tobuild, entrepreneurs could not finance them using just their own fundsand revenues from the business. Thus, construction was mainly financedby credit creationa frequent theme of Schumpeters writings. Hugeamounts of money flowed into the United States from Britain and Eu-rope, through the purchase of railroad bonds and the use of overdraftson banks. Some of these British overdrafts were granted with almostunbelievable freedom and carelessness. In the United States itself,credit creation was often even more recklessbut it was also extremelyinnovative.50

The pattern of railroad finance exemplified for investors the tumul-tuous business cycles typical of capitalist economies. By the time of theworldwide depression of 1873, the ups and downs of railroading hadmade it clear that the process of liquidation, absorption, adaptationthe frequent companion of innovationwas going to be an unusuallylong and painful affair. Railroads had brought an entirely new level offinancing, particularly through stocks and bonds. In America duringthe 1850s, this movement gave birth to modern Wall Street. And, by1897, net capital of the railroads stood at $9,168,072,000, an almostunimaginable sum for that time.51

49 Ibid., 33941.50 Ibid., 32830. Schumpeter here takes the trouble to note that what he is saying is not

controversial and has often been emphasized and never been contested by other scholars.His overall point was the vital importance of credit creation, which he often identified as oneof the defining traits of capitalism.

51 Ibid., 33839, 383.


Railroadization, then, was Schumpeters standard example bywhich to illustrate the working of [his] model. Hundreds of innova-tions emerged, both large and small. Great sums of money changedhands, the speed of commerce leapt forward, and a vast array of newproducts reached national markets. All these characteristics combineto make the essential features of our evolutionary process more obviousin this than they are in any other case.52

Corporations and Big Business. Just as railroads fostered newforms of financing, so did they also propel the growth of corporations.The corporate form represented a vital organizational innovation, butits development took a long time. The first corporations were organizedmostly in the sixteenth and seventeenth centuries as legal frameworksfor the discharge of some public function: municipalities, guilds, univer-sities. But from the sixteenth century to the nineteenth, the function ofthe corporation gradually changed. It implied raising capital, Schum-peter writes, which was first done (even in the case of the East IndiaCompany) for each individual venture. From this practice there ulti-mately emerged the independent and impersonal capital of the com-pany, not just that of its shareholders as individuals.53

In this new arrangement, shares could be bought and sold among apotentially infinite number of investors. For all this to happen, saysSchumpeter, both legal and financial devices had to be invented inquite the same sense as the steam engine had to be invented. In mostinstances, the monarch or the legislature created early corporationsone at a time, through specific acts. Typical corporate charters went toinvestors in state-sponsored enterprises, such as canal companies andbanks, some of which operated as monopolies.54

The modern corporation came later, through the privilege of freeincorporation by what Schumpeter calls administrative assent. Bythe second half of the nineteenth century, entrepreneurs in Britain, theUnited States, and a few other countries could launch their new compa-nies by simple registration in the jurisdictions where they did business.55

The corporate form prevented forced liquidation of a business whenone or more partners died or wished to dissolve the partnership. Lim-ited liability enabled people to participate more freely in the economyas investors, without incurring unlimited personal risk. The separationof ownership from control created opportunities for talented managersto lead great enterprises. At the same time, the secondary market for

52 Ibid., 3034.53 Ibid., 24547.54 Ibid., 24447.55 Ibid., 24447, 280, 307.


corporate shares, managed mostly by stock exchanges, allowed holdersof stocks and bonds to convert their investments into cash at a time oftheir own choosing.56

In Schumpeters mind, railroadization was the best example of en-trepreneurship facilitated by corporations. New types of men took holdof them, very different from the type of earlier railroad entrepreneurs.Although this trend had begun as early as the 1850s, the need for a newmanagerial class peaked in the 1890s. By that time, the new managersserved as organizers and financiers, carrying out complex tasks ofliquidation and reconstruction . . . combination, amalgamation, andmerger.57

The consolidation of the railroad system foreshadowed hundredsof other mergers in manufacturing, distribution, and retailing. Throughmergers, entrepreneurs sought to stabilize prices and reduce what con-temporaries called cutthroat competition. Schumpeter saw the rise ofbig business, including the merger movement, as a major innovation infinance and management carried out by New Men and New Firms. Un-like social critics who fretted over this trend, he believed that giantcompanies brought great advantages: new units of control, new prin-ciples of management, new possibilities of industrial research, and, atleast eventually, new types of plant and equipment. They also facili-tated the absolute optimum way to commercialize new technology.58

56 Schumpeter does not go into every detail covered here. All were well known by studentsof the corporate form. While he was composing Business Cycles, he wrote a fellow scholarwho had studied joint-stock companies that statistical time series were very helpful, but notsufficient. Therefore we must turn to industrial and financial history in order to find outwhat has actually happened in the economic organism year by year, and it is only when wehave done this that the true meaning of the fluctuations displayed by the time series revealsitself. This is why I think economic history of such paramount importance for the under-standing of the business cycle and even of the most practical contemporaneous problems.Schumpeter papers, general correspondence, letter, Schumpeter to Bishop C. Hunt (13 June1935), in box 1, HUG (FP) 4.8, Harvard University Archives.

57 Business Cycles, vol. 1, 4023. The literature on American railroads is, of course, enor-mous. Good starting points are the old works by John F. Stover, American Railroads (Chi-cago, 1961); and Alfred D. Chandler Jr., ed., The Railroads: The Nations First Big Business(New York, 1965).

58 Business Cycles, vol. 1, 4034. Schumpeter lays heavy emphasis on the merger move-ment, but he does not give many statistics. From 1897 through 1904, 4,227 American compa-nies merged into 257 large entities, many of whose names are still familiar today. On mergerwaves, see Jesse Markham, Survey of the Evidence and Findings on Mergers, in BusinessConcentration and Price Policy (Princeton, N.J., 1955), esp. 157; Ralph Nelson, MergerMovements in American Industry, 18951956 (Princeton, N.J., 1959); Thomas K. McCraw,Prophets of Regulation (Cambridge, Mass., 1984); and Naomi R. Lamoreaux, The GreatMerger Movement in American Business, 18951904 (Cambridge, U.K., 1985).

Many scholars have debated over whether Schumpeter believed innovation to behelped or hindered by the rise of big business; and, much more critically, about the facts ofthe proposition. The answer to the first question is that Schumpeter was himself inconsis-tent; but beginning with some of his articles written during the late 1920s, more so in Busi-


While acknowledging some destructive abuses, Schumpeter arguesin Business Cycles that the rise of big business was a logical phase inthe growth of industrial economies. One circumstance had been obvi-ous to him even before he moved to the United States: the emergence ofentrepreneurial startups always proceeds uninterrupted alongside therise of Big Business. This stark fact refuted general charges that oppor-tunities to succeed in New Firms had suddenly stopped.59

As usual, Schumpeter approached this issue by taking the longview. He understood why many politicians and social critics protestedagainst damages to incumbent craftsmen, small businesspeople, andunskilled workers. But to him it remained obvious that innovationsdrove entire national economies forward, and that long-term progressfar outweighed short-term pain. Regarding the disproportionate politi-cal power of large corporations, he believed that the function of controlbelonged to governments, not to the private sector. But, as he wrote inmany of his works, this required intelligent civil servants wielding acareful hand, lest they stifle entrepreneurship.

Automobiles and Steel. In addition to railroadization, another ofSchumpeters favored examples of capitalist growth was the automo-bile. The manufacture of cars combined many innovations: inter-changeable parts, modern machine tools, the internal combustion en-gine, and new ways to make steel. The whole process was a purelyentrepreneurial achievement turning to new uses not only existing re-sources but also existing technology. Schumpeter notes that most of

ness Cycles, then explicitly in Capitalism, Socialism and Democracy and several articles thatappeared during the 1940s, he usually argued that size in and of itself does not preclude in-novation, and can promote it in ways that would not occur in small business. On the secondquestion, about two dozen useful articles have been published on the somewhat misnamedSchumpeter hypothesis that large firm size is advantageous to innovation. Two of the bestare F. M. Scherer, Schumpeter and Plausible Capitalism, Journal of Economic Literature30 (Sept. 1992): 141633; and Tom Nicholas, Why Schumpeter Was Right: Innovation,Market Power, and Creative Destruction in 1920s America, Journal of Economic History 63(Dec. 2003): 102358.

59 This argument pervades many of Schumpeters writings and is implicit throughout thetext of Business Cycles. On page 405 of volume 1, for example, he speaks of the travelingsalesman who turned into a promoter of combinations. In many of his articles written inGerman during the 1920s, as in Business Cycles, he insists that entrepreneurs come from allsocial classes. And in Capitalism, Socialism and Democracy, he mounts a pointed attack onAmericans denunciations of big businesses as monopolies. He was especially annoyed withwhat he regarded as his fellow economists misunderstanding of the issue. Against their prej-udices, as he said in his presidential address to the American Economic Association in 1948,no argument avails about the performance of largest-scale business, about the inevitabilityof its emergence, about the social costs involved in destroying existing structures, about thefutility of the hallowed ideal of pure competitionor in fact ever elicits any response otherthan the most obviously sincere indignation. Schumpeter, Science and Ideology, Ameri-can Economic Review 39 (Mar. 1949): 34559.


the technological problems were worked out in France and Germanyduring the 1890s and early 1900s. But the real automotive innovationscame in the United States, where in 1908 Henry Ford introduced theModel Tthis great new thing, as Schumpeter calls itnot for the richbut for the masses. Whereas a Packard sold for $5,450, the first Model Tcost a mere $850, and the 1912 version, only $600. By 1920 the priceof a Model T had dropped to $440, and by 1924 to a hardly credible$290. Meanwhile, the quality of the car had improved even as its priceplummeted.60

By the mid-1920s, Ford was engaged in a battle with General Mo-tors, and within a few years, the entrepreneur Alfred Sloan and his eliteteam of GM managers had all but buried Ford in a blizzard of innova-tions. In creative financial techniques, Schumpeter writes, the industrywas almost in a class by itself. General Motors introduction of install-ment buying created an immense amount of credit by making con-sumers significant borrowers. This not only augmented sales and en-couraged trading up, but it also provided GM with a stream of currentincome from interest payments. And customers who did not want tobuy on time paid cash, through loans from banks. This enabled manu-facturers to minimize their own borrowing. No better instance, writesSchumpeter, could be found to show how credit creation for the pur-pose of innovation can hidethat is, how invisibly and subtly it can beintroduced.61

Schumpeter believed the car industry to be the best single exampleof how entrepreneurs ultimately win big money, as opposed to thosewho try to keep prices high by limiting production. Competitors crowdedalong, he writes, and, in an industry requiring but little capital, notonly hovered around, but actually entered the field. Only, most of themfailed to produce a car that would sell at a price covering cost, therebeing absolutely no other reason for this than the one embodied in ourtheory of entrepreneurial activity. Coincidence of high mortality and

60 Business Cycles, vol. 1, 41516. See, for the statistics and details, James J. Flink, Auto-mobile, in Glenn Porter, ed., Encyclopedia of American Economic History (New York,1980), 116893; and Alfred D. Chandler Jr., ed., Giant Enterprise: Ford, General Motors,and the Automobile Industry: Sources and Readings (New York, 1964), 12, and variouspages. The standard history of mass production in the United States, which contains muchmaterial on the automobile industry, is David A. Hounshell, From the American System toMass Production, 18001932: The Development of Manufacturing Technology in the UnitedStates (Baltimore, 1984).

61 Business Cycles, vol. 1, 415. For details, see Alfred P. Sloan Jr., My Years at GeneralMotors (New York, 1964), ch. 9; Richard S. Tedlow, New and Improved: The Story of MassMarketing in America, ch. 3; Arthur J. Kuhn, GM Passes Ford: Designing the General MotorsPerformance-Control System (University Park, Penn., 1986); and Daniel M. G. Raff, MakingCars and Making Money in the Interwar Automobile Industry: Economies of Scale and Scopeand the Manufacturing behind the Marketing, Business History Review 65 (Winter 1991).


high profits ideally expresses this situation. The auto story shows howrealistic the fundamental distinction is between the behavior of themere economic man and the entrepreneur.62

Entrepreneurs built their auto empires in significant part on thefoundation of steel, which has its own history of technological and or-ganizational breakthroughs. As Schumpeter emphasizes, the key devel-opment for both cars and steel was sharply declining prices. The changein steel began in Britain with the introduction of Henry Bessemersmass-production process in the 1850s, and Schumpeter lauds Bessemerspurity as one of the types that enter into our concept of entrepreneur.63

In the beginning, Bessemers contemporaries regarded him as aninventor. But he was much more than that, and even his outstandinginvention can hardly be called a scientific novelty. The use of the airblast . . . and, of course, the converter, were old and common knowl-edge. Real genius, but of the typically entrepreneurial kind, was in thevision of the vast possibilities for cheap steel. Pursuing this goal, Besse-mer combined existing methods with new ones. He then patented hissystem and waited for an onrush of licensees. When few appeared,Bessemer entered the field himself, moving to Sheffield with the inten-tion of underselling the top firms. His steel was of excellent quality,though not yet as inexpensive as he knew it would become. He had rel-atively quick successnot against other steelmakers, the enemy it hadbeen his intention to attack, but over the producers of wrought iron.Soon Bessemer and his imitators were making rails for the boomingrailroad industry, woven steel for bridge cables, and steel plates forships. Even so, during the 1860s, traditional resistance to innovationsand Bessemers relatively high prices restricted the wide use of steelthat was to come.64

At this point, competition between the Bessemer process and theeven newer open-hearth method pioneered by William Siemens beganto drive production up and prices down. British firms produced 77,500tons of open-hearth steel in 1873, a figure that shot up to 436,000 tonsin 1882. By 1896, they were turning out 2.4 million tons, in addition to1.8 million tons manufactured by the Bessemer process.65

American steel production at first lagged behind British output butrapidly overtook it in the closing decades of the nineteenth century.Near Pittsburgh, Andrew Carnegies iron firm built the Edgar ThomsonSteel Works. This was Carnegies first Bessemer plant, andwith typi-

62 Business Cycles, vol. 1, 416n.63 Ibid., 372.64 Ibid., 37273.65 Ibid., 373.


cal marketing geniushe named it in honor of his former boss and bestcustomer on the Pennsylvania Railroad. Carnegie then expanded bybuilding or acquiring ever more modern steel mills at nearby Home-stead and Duquesne. At the same time, Illinois Steel, Colorado Fuel andSteel, and a few other companies followed Carnegies example.66

Electricity. Even more important than cheap steel was the devel-opment of electricity, which Schumpeter regarded as a New IndustrialRevolution. Business applications of electricity had begun as early asthe 1840s, with the telegraph. But not until about 1914 was the victoryof electricity certain. The key steps were the development of Edisonsincandescent lamp and the innovation of alternating current, whichmade possible long-distance transmission of electric power. Therequickly followed improvement of hydroelectric motors, constructionof hydroelectric and thermoelectric plants of ever-increasing capaci-ties, and the victory of big power stations over the [small private]plants of individual industrial consumers.67

Gigantic turbines at Niagara Falls went into operation in 1895 (man-ufactured by German firms, a point Schumpeter neglects to mention).Hydroelectric companies in other regions, led mostly by local entrepre-neurs, followed in quick succession: In New England (Holyoke WaterPower Company), on the Mississippi (Keokuk), in Montana (Great Falls),on the St. Marys River (Consolidated Lake Superior Company). Manycompanies prospered on the Pacific Coast and in the South, in additionto large firms such as the Southern Power Company, the AlabamaPower Company, and the hydroelectric plants of Alcoa in Tennessee. Asthese firms began to buy and sell current among themselves, the nationselectrical infrastructure grew in more or less the same way its railroadnetworks had done earlier.68

Much came down to individual entrepreneurs talent for seizing op-portunities of the moment. One essential peculiarity of the working ofthe capitalist system is that it imposes sequences and rules of timing.Nearly every company that could benefit from electric power now hadto innovate, whether it wished to or not. Electricity provided the heatnecessary to refine copper and aluminum ores. Electric motors spunand wove textiles, pumped water from mines, milled lumber with high-speed saws, and shaped metal with power drills and stamping machines.For success in capitalist society, Schumpeter says, it is not sufficientto be right in abstracto; one must be right at given dates. And although

66 Ibid., 388; for details, see Harold C. Livesay, Andrew Carnegie and the Rise of BigBusiness (Boston, 1975).

67 Business Cycles, vol. 1, 397, 398, 412.68 Ibid., 41213.


he wrote Business Cycles in the midst of the Great Depression, Schum-peter sums up the story of electrification with an optimistic message:new uses for electricity were everywhere. No single industry, he empha-sizes, had yet been fully electrified, let alone all households. And theelectrification of farms had hardly begun.69

As was his habit, Schumpeter took pains to name the leading firms.Electrical equipment was produced by the General Electric and theWestinghouse concerns and also by many other firms, some datingfrom the [eighteen] eighties (as, for instance, the Electric Storage Bat-tery Company). Some of the most important ones were highly special-ized (Electric Boat Company, National Carbon Company.) The indus-try also developed a healthy export market: The equipment of theLondon Underground Railway was supplied by American firms (1897).Meanwhile, of course, not every attempt succeeded. It should not beforgotten that in 1914 there were still above 40 firms fighting the losingfight of the electric automobile.70

As he does throughout Business Cycles, Schumpeter compares onecountrys history of innovations with anothers. In Germany, the cruxof electrical enterprise was power finance. Only the largest manufac-turing companies could afford to enter the business of generating andtransmitting electricity. They did so through allied financial subsid-iaries (banks), which underwrote local power systems as markets forthe parent manufacturers. Three large concerns led this movement: thebank for Electrical Securities, headquartered in Berlin and allied withAEG (German General Electric, which had no relation to the Americancompany GE); the Continental Company for Electrical Enterprises, aSiemens affiliate centered in Nuremberg; and the bank for ElectricalEnterprises, which targeted international business from the beginningand was located in Zurich.71

But unlike America, Schumpeter points out, Germany resortedto public enterprise, as well, at a comparatively early stage. Occasion-ally this led to conflicts but in general this form of municipal socialism(and also action by provincial bodies and states) was welcomed by themanufacturing industry. Public credit was thereby added to private fi-nancing, and by the beginning of the twentieth century, most of Germanywas supplied with electricity.72

69 Ibid., vol. 1, 412; vol. 2, 77172.70 Ibid., vol. 1, 413. For a detailed overview, see Alfred D. Chandler Jr., Scale and Scope:

The Dynamics of Industrial Capitalism (Cambridge, Mass., 1990), 21221, and AppendixA.1, 642.

71 Business Cycles, vol. 1, 43940. The authoritative comparative history of electrificationin the U.S., Germany, and Britain is Thomas Parke Hughes, Networks of Power: Electrifica-tion in Western Society, 18801930 (Baltimore, 1983).



Several German firms, replete with staff engineers, had a big ad-vantage in their drive to capitalize on electricity. Schumpeter notes thatelectrical technology had long since become an applied science whichit was possible to learn and to develop in laboratories and schools. Thetechnical departments of established German companies were so wellstocked with New Men that it proved unnecessary to set up New Firms.In this advantageous situation, the entrepreneurs being largely em-ployees, German firms were by 1913 manufacturing about one-third ofall electrical products in the world. No fewer than three of Germanyssix largest industrial companies produced electrical equipment: AEG,Siemens-Schuckert, and Siemens-Halske.73

In Britain, meanwhile, the making of electrical machinery laggedbehind, and no British company competed effectively with the Ameri-can and German giants. Most of the national market was supplied byimports from General Electric, Westinghouse, AEG, and the two Sie-mens firms, or by local subsidiaries of these four companies. British en-trepreneurship signally failed in an obvious and purely economic task.So, in contrast to the United States, the government had to fill the void.By 1929, public agencies owned more than 70 percent of Britains sup-ply system. This National Grid turned out to be a useful model forpublic projects in other countries. But from the beginning Britain couldnot compete with the United States and Germany in the industries thatsupplied electrical equipment.74

The Model and Business History

Let us now review Schumpeters analytical model. Above all, hepinpoints the role of Innovation. The drivers of Innovation are the En-trepreneur, the New Firm, and entrepreneurial Profit. The continualcreation of credit is vital. The essence of the whole system is change,which is fiercely resisted by those with a stake in things as they are.

73 Ibid., 44041. See Chandler, Scale and Scope, 46374, and Appendix C.1, 703. Therankings are by assets.

74 Business Cycles, vol. 2, 75758. Subsequent research confirmed Schumpeters argu-ment here. Whereas three of the top six German industrial firms made these products, andtwo of the top seventeen American firms, the largest British electrical manufacturing firmranked number fifty among the nations industrial companies, and the second largest rankednumber fifty-four. Neither produced much heavy equipment, specializing instead in light-bulbs and other small items. The three next largest British electrical companies were localsubsidiaries of the German and American giants. At the beginning of World War I, two-thirdsof the output of electrical equipment in Britain came from subsidiaries of General Electric,Westinghouse, and the Siemens companies. After the disruption of trading patterns duringWorld War I, British companies did somewhat better. But they did not catch up with theAmerican and German giants. See Chandler, Scale and Scope, 276, and Appendix B.1, 671.


Read in the way I have reconfigured it here, Business Cycles suc-ceeded brilliantly as a new way of analyzing the history of business; andthe basic model remains to this day a useful starting point for certaintypes of studies. Capitalist evolution spells disturbance, Schumpeteremphasizes again and again. Capitalism is essentially a process of(endogenous) economic change. In the absence of change, capitalistsociety cannot exist. And the key that starts the engine and keeps itrunning is Innovation:

Without innovations, no entrepreneurs; without entrepreneurialachievement, no capitalist returns and no capitalist propulsion. Theatmosphere of industrial revolutionsof progressis the only onein which capitalism can survive.75

One perceptive reviewer noted that Business Cycles was Schum-peters interpretation of the history of capitalism. That and nothing elseis the actual goal of the book. Schumpeter himself notes that his sub-title, A Theoretical, Historical, and Statistical Analysis of the Capital-ist Process, really renders what I have tried to do. His preoccupationwith the evolution of business and his mention of scores of individualfirms by name confirm that Business Cycles is as much a work of his-tory as of economics, if not more so.76

Oddly enough, references to actual companies were not common inscientific writing by economists at the time. Such references are al-most nonexistent in the field today, and rigorous historical analysis offirms and industries has become the purview of business history, whicheven now is still a relatively new subdiscipline. Before the appearanceof Business Cycles, business history had been in existence for only afew years.77

75 If an existing capitalist system did somehow stabilize, Schumpeter went on to say,There would be increasing reluctance to invest or even reinvest, a tendency to live on capi-tal, to hold on to balances, to recreate vanishing returns by all the shifts open to a classwhich, though by then economically functionless, yet would, like its feudal predecessor, for atime retain the powers acquired by and associated with the functions previously filled. Mal-adjustments, unemployment and underutilization of resourcesthough now of a differentnatureand neutral, unstable, and subnormal equilibria might hence well stay with a nonex-panding world. This statement, unlike much of the rest of Business Cycles, accords withKeyness argument in The General Theory. But Schumpeter believed that stabilized capital-ism is a contradiction in terms. Business Cycles, vol. 2, 907, 1033.

76 J. Marschak, Journal of Political Economy 48 (Dec. 1940), 893; Schumpeter, BusinessCycles, vol. 1, v.

77 I am generalizing broadly here, and several exceptions come to mind: the work of mem-bers of the German Historical School, who produced numerous studies of industries and firms;and N. S. B. Gras and Henrietta Larson of Harvard Business School. Still, in these examples, thekind of theoretical rigor characteristic of Schumpeters work was largely absent. In the UnitedStates, the empirical work of a few economists senior to Schumpeter, such as William Z. Rip-ley, Charles Van Hise, John R. Commons, Arthur Hadley, and Frank Taussig, was theoreti-cally well grounded. But it would be a stretch to characterize their work as business history.


Obviously, there is a great deal to say on this subject. But in whatSchumpeter liked to call a spirit of desperate brevity, I will limit mycomments to a few paragraphs:

In 1927 Harvard Business School established a chair in businesshistory, endowed by the family of Isidor Straus, the guiding entrepre-neur of Macys Department Store who had died in the 1912 sinking ofthe Titanic. The first occupant of this chair was Norman S. B. Gras, aCanadian economist who had trained under Edwin F. Gay, a professorin Harvards Department of Economics and later the founding dean ofthe universitys business school. Gras, one year younger than Schum-peter, had written several useful books in economic history. In the sameyear that Schumpeters Business Cycles appeared, Gras brought out atextbook, Business and Capitalism: An Introduction to Business His-tory, and, together with his able colleague Henrietta Larson, had pro-duced an enormous volume, Casebook in American Business History.78

Curiously, it appears that there was little or no communication be-tween Gras and Larson, on the one hand, and Schumpeter, on theother. Schumpeters office was just across the Charles River from theirs,and throughout the 1940s, Schumpeter spent innumerable hours in theKress Library of rare books, located inside the business schools BakerLibrary. There he did an immense amount of research for his monu-mental History of Economic Analysis (1954).79

The most direct personal influence Schumpeter had on the evolu-tion of business history came through his participation in the Center forResearch in Entrepreneurial History, which led a precarious but pro-ductive existence at Harvard from 1948 until 1958. Schumpeter as-sisted his friend Arthur Cole in persuading the Rockefeller Foundationto fund the Center. He attended its early meetings and presented twoprovocative papers. But he never took the lead in the Centers activities.He was thoroughly immersed in his own work, which included Historyof Economic Analysis and the organization of the 1948 program of theAmerican Economic Association, of which he was president. These tasksconsumed most of Schumpeters time during the seventeen monthsbetween the Centers founding and his death in January of 1950.80

78 Both books were published in New York in 1939.79 I have found no correspondence between Schumpeter and Gras in the private papers of

either man, nor other evidence of personal contact. On Gras, Larson, and their approaches tobusiness history, see Barry E. C. Boothman, A Theme Worthy of Epic Treatment: N. S. B.Gras and the Emergence of American Business History, Journal of Macromarketing 2 (June2001): 6173; and Mary A. Yeagers analysis of the work of Larson: Mavericks and Mavensof Business History: Miriam Beard and Henrietta Larson, Enterprise and Society 2 (Dec.2001): 687768.

80 The principal leaders of the Center were Cole, the sociologist Leland Jenks, the histo-rian Thomas C. Cochran, and the European polymath Fritz Redlich. The list of young schol-ars who participated in the Centers activities reads like an all-star team of historians over the


During the late 1940s, Alfred D. Chandler Jr. met Schumpeter briefly.(He had taken no courses from Schumpeter during his undergraduateyears at Harvard, 193640.) Chandler was influenced by Schumpeter,mostly through Arthur Cole, Fritz Redlich, and especially Talcott Par-sons, who affected Chandlers thinking more than any other scholar. Asociologist, Parsons had worked with Schumpeter for more than a de-cade, sometimes closely. He had been a graduate student when Schum-peter first came to Harvard as a visitor in 1927, before the sociologistssplit off from Economics. Parsonss structural-functionalism had a verypowerful impact on Chandlers approach to business history.81

The fragmented three-country historical study that Schumpeterembedded in Business Cycles was consummated in grand style fifty-oneyears later in Chandlers Scale and Scope: The Dynamics of IndustrialEnterprise (1990). Prior to the publication of Scale and Scope, Chan-dler had pursued business history with tenacious single-mindednessfor more than forty years. He had written numerous articles and four

next generation: Alfred D. Chandler Jr., Bernard Bailyn, David S. Landes, Hugh G. C. Aitken,Douglass North, Henry Rosovsky, and John Sawyer, among others. See Steven A. Sass, En-trepreneurial Historians and History: Leadership and Rationality in American EconomicHistoriography, 19401960 (New York, 1986); Hugh G. C. Aitken, ed., Explorations in En-terprise (Cambridge, Mass., 1965), esp. pp. 811 and 2426, which describe Schumpetersrole; and Ruth Crandall, The Research Center in Entrepreneurial History at Harvard Uni-versity, 19481958: A Historical Sketch (Cambridge, Mass., 1960).

Schumpeters main paper, presented in furtherance of the establishment and the intel-lectual life of the Center, is Comments on a Plan for the Study of Entrepreneurship, likelywritten in 1946, and printed in Richard A. Swedberg, ed., Joseph A. Schumpeter: The Eco-nomics and Sociology of Capitalism (Princeton, N.J., 1991): 40628. Here, among a rich menuof arguments, Schumpeter calls for a comparative analysis of industries and companiesthrough standard sets of questionsa method that came to characterize Chandlers work (seepp. 42224 in particular). Among existing studies, Schumpeter especially praises Fritz RedlichsHistory of American Business Leaders: A Series of Studies (Ann Arbor, 194051); andArthur C. Cole and Harold F. Williamson, The American Carpet Manufacturers: A Historyand an Analysis (Cambridge, Mass., 1941) as exemplars of entrepreneurial history. A con-densed version of the paper was published in 1947 as The Creative Response in EconomicHistory. On 2 Jan. 1947, Arthur Cole reported that, after a conference in December 1946,Schumpeter had composed a vigorous polemic in favor of continued research in the area [ofentrepreneurship] and particularly for the establishment of a central coordinating bureau orinstitute (Crandall, The Research Center, 8). Once the Center was established, Schumpeter,on 7 Oct. 1948, delivered its second paper (Cole had given the first), titled Economic Theoryand Entrepreneurial History, published by the Center itself in Change and the Entrepre-neur: Postulates and Patterns in Entrepreneurial History (Cambridge, Mass., 1949): 6384.

81 Chandler, personal communication; Chandler has no recollection of reading BusinessCyc

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