Capitalism

2

Schumpeter and Keynes

Money in Adam Smith's scheme was considered to be no more than a neutral medium that facilitated exchange on the 'great wheel of circulation'. Capital was understood primarily in physical terms as 'stocks' - the instruments of production and raw materials. These were the 'real' factors of production and they were not to be confused with the mere 'wheel' - that is, the money by which they were circulated (Smith 1986 [1776]: 385).1 Similarly, Marx sharply distinguished money-capital and credit from the means of production, and frequently referred to the former as 'fictitious' capital. But as the capitalist system developed during the nineteenth century, its distinctive monetary and financial character became clearer and these elements began to assume a more prominent place in the analyses of the economy. The idea began to take shape that money was more than a mere medium of exchange and a measure of the value of actual existing physical capital; rather the creation of credit-money was an autonomous force in capitalist development.

Joseph Schumpeter (1883-1950): money markets as the 'headquarters of capitalism'

Schumpeter crossed disciplinary boundaries as they were developing during the first half of the twentieth century, but not to the same extent and with the same conviction as Weber (see Schumpeter's magisterial posthumous History of Economic Analysis, 1994 [1954]). On the one hand Schumpeter was attracted to the mathematical sophistication of the equilibrium models of academic economics, but he also saw the importance of the historical study of economies and admired Marx's project and method, if not its details and conclusions. The result was ambivalence about the best way to study capitalism, but Schumpeter's seminal contribution is precisely the result of this tension. His work sought to resolve two related problems in the theoretical understanding of capitalism. First, Schumpeter concluded that Smith's 'circular-flow' model, which was the foundation of the equilibrium theories he admired, could not explain the definitive characteristics of capitalism that Marx had correctly identified - that is, the realization of monetary profits and the continued dynamic expansion of the means of production. Schumpeter's second criticism of economic theory was that the function accorded to money in its circular-flow model meant that it was unable to grasp the particular financial character of capitalism.

In classical economic theory no factor should receive more in income than its input, as measured precisely by costs, to the process of production. We saw earlier that revenues accruing to each factor of production, in Smith's model, are consumed in the subsequent sequential phases of the productive process. Supply and demand in the competitive market eventually ensure that no factor can receive more revenue than that which covers its costs. Schumpeter agreed with Marx's critique that this does not account for profits and any accumulation of surplus for investment (Schumpeter 1961 [1911]: 30-2). In short, capitalism's capacity for dynamic growth and constant revolutionary transformation of the means of production could not be explained by the static 'circular-flow' model.

These distinctive characteristics of capitalism are frequently explained in economic theory as the result of 'exogenous' factors such as technological invention. But what called forth the new techniques and ensured their application? It was difficult to see how the 'invisible hand' could do this without the assumption that it would be profitable for individuals to do so. But the 'circular-flow' model did not contain profits. Nor did it contain a further distinctive element in capitalism that Weber had touched on - the creation of bank credit-money. In short, Schumpeter set out to resolve these inconsistencies and anomalies in Smith's model and to explain what capitalists actually did.

Profits and the role of the capitalist entrepreneur

The implication of Smith's and other economists' models of the circular flows of production, distribution and consumption in which the entrepreneur merely plays a passive role, responding to price signals in the market, is clearly at odds with the reality of capitalism's dynamism. On the contrary, Schumpeter argued, the entrepreneur is a key figure whose role is constantly to revolutionize the system by restructuring the factors of production in new ways that yield a profit for the initiator either by an increase in their productivity or by the production of new goods. In other words, the entrepreneur doesn't simply compete, but, rather, changes the nature of the competition (Schumpeter 1961 [1911]). Old industries and methods are swept away in a process of 'creative destruction'. In capitalism, however, this is only a temporary advantage, as others are free to adopt the innovations and enter the new sector. The ensuing competition drives down prices, as Smith's 'circular-flow' model predicts, and the subsequent falling profits lead to a 'destructive' phase.

Unlike Marx's vision of a cataclysmic collapse of capitalism, falling profits in the 'destructive' phase are not terminal for the system, as entrepreneurs continue to search creatively for profitable innovation. Schumpeter adds that this dynamic process is accelerated by the existence of a certain degree of monopoly which gives some protection in the initial costly and risky stages of innovation. That is to say, monopoly plays a positive role and is not necessarily as inefficient as it is in the model of the perfectly competitive market (see the discussion in chapter 5).

In addressing the supplementary, but essential, question of how entrepreneurial innovation was made possible, Schumpeter observed that the entrepreneur was the only economic agent in capitalism who was a debtor by the nature of his economic function (Schumpeter 1961 [1911]: 70-4). His analysis of the process by which capitalism was carried on with borrowed money involved a further departure from a 'circular-flow' model.

Capitalism and credit-money

Schumpeter located the rise of capitalism in the development of the law and practice of transferable debt and 'created' deposits in an emerging banking system during the sixteenth and seventeenth centuries, not in the nineteenth century's industrialism (Schumpeter 1994 [1954]: 78). (These monetary innovations are considered further in chapter 4; here we may simply note that transferable debt refers to the practice whereby a creditor is able to use their debtor's acknowledgement of debt - an IOU - as a means of payment to a third party.) The 'capitalist engine' could not be understood at all, Schumpeter contended, without reference to its credit operations and distinctive monetary system (Schumpeter 1994 [1954]: 318). The money markets were the 'headquarters' of capitalism (Schumpeter 1961 [1911]: 126); it was access to credit-money that drove the capitalist system.

At this time, most economic theory, and common sense, understood savings, finance and investment in a similar way to Smith's 'circular-flow' model. Here, as Schumpeter observed, banks are merely intermediaries between savers and borrowers, creating financial reservoirs by collecting together little pools of savings for lending on. But, as we have already noted, Schumpeter and others saw that capitalist banks produced new money by the act of lending, in the sense that the deposits that were created when money was advanced to a borrower were not taken from existing savings or matched by incoming deposits (Schumpeter 1994 [1954]: 319-20, 1113). Money was produced simply by the debt contract between banks and borrowers.2 Schumpeter clearly grasped that the essential capitalist practice was the actual 'production' of bank credit-money out of nothing more than the promise of repayment (Schumpeter 1961 [1911]: 70-4).

The idea that money was capital had been roundly criticized by Smith and the classical economists as an error perpetrated by false mercantilist doctrines. As we have noted, capital was rather to be seen as 'stock' - tools, materials and other physical means of production. This was 'real' wealth; money was simply the means for exchanging it in the form of goods, or for representing their value symbolically. Additionally, in the era of precious-metal money, credit instruments - such bills of exchange and promissory and bank notes - were to be distinguished from 'real' money. Thus, although credit was important in facilitating trade and production it was not an autonomous force or factor of production, which could only be physical capital 'stocks'. Schumpeter moved towards a different view which gave a clearer account of the workings of the capitalist system. As we shall see in chapter 4, he favoured a credit theory of money - that is to say, all money, regardless of form and substance, is a token claim or credit. Moreover, he also considered that we would have avoided these 'downright silly controversies' about whether credit was money or whether money was capital if economists had kept to the Roman jurists' conception of capital as 'essentially monetary' (1994 [1954]: 322-3).

Schumpeter's efforts to resolve what he saw as the anomalies and inconsistencies of the 'circular-flow' model of the economy had led him, not without equivocation and...