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THE ECONOMICS OF
goHN MAYNARD KEYNEs AND
A JosEpH A. SCHUMPETER  
A DESCRIPTION AND COMPARISON

' . Thesis Ear the Degree of. M A.
I ' ' _ MICHIGAN STATE COLLEGE
; _ ‘ ' " . Ciayton CIyde Curtis
 . . ' I950;

 

 

 

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The Economics of
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Joseph A. Schmnpeter
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THE ECONOMICS OF JOHN MAYNARD KEYNES AND JOSEPH A. SCHUMPETER

A DESCRIPTION AND CONPARISON

by
Clayton Clyde Curtis

A THESIS
Submitted to the Graduate School of Michigan State
College of Agriculture and Applied Science in
partial fulfillment of the requirements
for the degree of

MASTER OF ARTS

Department of Economics

1950

 

 

. n PI u‘l _ \' u'

ACKNOWLEDGEMDNT.

The author wishes to take this Opportunity to express
.his appreciation for the aid received in the preparation
of this manuscript. In particular the writer is deeply
indebted to Dr. V. E. Smith and Dr. L. Hall for both the
training received in their classes and the direct assistance
on this manuscript. Both men gave,unselfishly of their

own precious vacation time. J. Smookler and L. Hitter w_ [9;mmi"

both gave helpful advice and valuable contributions of
material.

Finally the author must express the deepest debt of
gratitude to his wife without Whose tireless work in
typing and preparation, this work would never have been com-
p13 ted.

The Author

2414584

Chapter
I

II

III

CONTENTS

Keynes: A Summary

The Schumpeterian System

The Parts Compared

The Overall View

Pages

29

53

83

CHAPTSR I
KEYNES: A SUMMARY

Before we begin our brief summary of the Keynesian sys-
tem, it would be well to outline the purpose of this chapter.
Our ultimate purpose, as the title indicates, is to conduct
a comparison of the economic systems propounded by Lord Keynes
and Joseph Schumpeter respectively. The comparison will be
carried out on two levels. We intend first to consider simi-
larities, if they exist, between fundamental components of
each system, i.e. the nature of capital, etc. Secondly, we
shall endeavor to decide what both systems in their entirety
have in common; that is to say, are the two authors answering
the same general questions; are the systems they have erected
mutually or partially substitutable, etc?

It is with the idea of providing some basis for this
latter, the comparison of the complete systems, that this
chapter and chapter two have been written. In summarizing
both systems the attempt has been made to simply condense
and record, as objectively as possible, the actual work
of these two men. This has left the summaries open to the
inevitable errors of selection and interpretation for which

the author assumes full responsibility. In general, the

material used is that embodied in The General Theory, but

the reader will note that a great deal of the work contained
in that volume, especially in the last half, is not considered.
Moreover, we shall jump immediately into our discussion with-
out the usual considerations of the classical position, in
objection to which the book was written.1 Two reasons are
advanced for the position thus taken: (1) In regard to the
omission of the latgr half of Keyners work, it is concerned
either with the applications of the approach, consistent

with the system advanced, or a more detailed exposition of
principles explained earlier in the text.2 As such, it is
not essential to a summary of the system. Moreover, the
material presented in this portion of the book is precisely
of the nature which we wish to use in the overall comparison
of the two men, and so we shall relegate its discussion to

-the later part of this thesis. (2) The relation of Keynesian

theory to classical is omitted because we are not attempting

 

l. The first two chapters of The Gengral Theory are so
devoted. D. Dillard's The Economics 9£_John Maynard Keynes,
and L. Klein's The Keynesian Revolution, also follow the same
pattern. For divergent Opinions on the question of Keynes
and the classicists, see selections by Seymour Harris(Chap.
VI), Wassely Leontief(Chap. XIX), and R. F. Harrod(Chap. XLI)
in The New Economics.

2. Chapter 22, Notes on the Trade Cycle, is given as an
example of what is meant by application, while Chapter 17,

The Essential PrOperties of Interest and honey, is an example
of further exposition of a principle already stated in Chapter
13. By the last half, is meant those from Chapter 14 on,

with the possible exception of Chapter 15. All chapters cited
refer to The General Theory g£_Employment, Interest A Money.

to place Keynes in historical perspective, nor are we con-
cerned with the numerous arguments over the correctness Of
his work or its real originality. For our purposes, the
system is considered as a de facto accomplishment Which we
accept, and any discussions or exceptions we wish to take
will be relegated to footnotes. Since the foundations,
i.e. the circular flow,of Schumpeter's system, might pro-
perly be termed classical, we shall be able to work many of
Keynes's objections into our discussion of the components
of each system. This aspect of the problem, then, shall in
reality not be completely neglected.

With the ground thus cleared, we have arrived at the
point where we may begin the discussion of Keynes.

I THE THEORY OF EFFECTIVE DANAND

If we were to pick one concept that summarized the Key-
nesian System it would be that of effective demand. 3 The
Keynesian problem was to construct a theory of the deter-
mination of the level of output, and the solution may be

stated in the concept Of effective demand.4 Now, while

 

OJ L. R. Klein in The Keynesian Revolution has character-
ized the theory of effective demand as Keynes's revolution-
ary contribution to theory (p. 56). For an excellent sum-
mary of the various Opinions on Keynes's real revolutionary
contribution, the readeri.s referred to Chapter VI in The
New Economics.

 

4. The term, "effective demand", is not original with Keynes,
but he has given it a new meaning; for example, see Knut Wick-
sell's Lectures on Political Economy, p. 19. Here the term

is used to diffeFEntiate between mere desire to buy and ability
to buy. L. R. Klein, Ibid., p. 126, notes that Malthuus used
effective demand in the Keynesian sense but had no clear idea
Of its determination.

this is a true statement, and indeed a truism, it is in and
of itself uninteresting, and we shall need to discover the
determinants of effective demand itself before we shall have
progressed very far. For the moment, however, let us return
to effective demand.

If we consider a simple entrepreneur, we are familiar
with the classical principle that he will attempt to maxi-
mize his profits by expanding his output to the point where
the cost of producing an extra unit is just covered by the
proceeds from that unit's sale. With Keynes, however, we
are concerned always with aggregates, so that instead Of
considering one entrepreneur we shall consider all at the
same time. Since the behavior Of all is assumed to be sim-
ilar, we shall not have damaged the conclusions applicable
to the single firm at all, but rather we shall have succeeded
in discovering what happens to total output and employment
with variations in entrepreneurial decisions.

Now, since employment varies directly with output,5
it follows that, ce terns paribus, employment will depend
on what level of output entrepreneurs in the aggregate ex-

pect will maximize their profits.6 In terms of aggregate

 

5. When we speak of an increase or decrease in either in-
come, employment, or output, we shall assume that all three
move in the same direction at approximately the same rate.
That this is Keynes's own assumption, the reader may verify
by consulting The General Theory, p. 90.

6. This argument and the following paragraph draws heavily
on J. M. Keynes, The General Theory gf employment, Interest
a Mono , Chapter 3.

functional relationships, our product will have as a minimum
supply price (Z) the cost of employing the number of men (N)
necessary to turn out that output. Thus, 2 - DIN), and this
is Keynes's Aggregate Supply Function. On the other hand
the entrepreneur expects, by employing a certain number of
men (N) to receive in sales D amount Of income.7 Thus,
D = f(N), and we have Keynes's Aggregate Demand Function.
From these two functions we may easily construct sche-
dules for each and arrive at our solution graphically. Thus,
for the demand schedule we may construct a series of expected
receipts coincident with a series of various amounts Of em-
ployment. Now since greater amounts of employment will pro-
duce greater outputs, and consequently greater anticipated
returns, the demand curve derived from this schedule will
slope upward and to the right.8 In figure one we have repre-

sented this curve with line DD.

 

7. This is income both to the entrepreneur and his factors,
because it is the entire proceeds from sales, the gross sales
in the language Of the business man. In another sense, how-
ever, this income is net, for from it have been subtracted

the amounts paid to other entrepreneurs, and the sacrifice
incurred by using the equipment instead of letting it remain
idle. In short, this is income net of user cost. For a fuller
explanation of user cost, the reader is referred to Chapter

5 and 6 of The General Theory.

8. The curve will not, however, be a straight line, because
with greater amounts of employment, diminishing marginal pro-
ductivity will result in smaller relative output per worker
employed, causing the demand curve DD to bend down to the
right as N increases. It might also be argued that since this
is expecteg_proceeds, the bending is a result of the entrepre-
neurh familiarity with the Old law of supply and demand, i.e.

amuse I

 

 

 

hauQHBkw

EMPLOYMDNT

Similarly, for the supply schedule we may take a series
Of receipts and the coincident series of amounts of employ-
ment which would ju§t_be induced by these receipts. This
curve, too, would sIOpe upward and to the right, since as a
greater number of workers are employed, the proceeds necessary
to cover their added costs also increase. This is the curve
22 in Figure 1. The supply curve does not exhibit the same
bending as the demand curve, hOwever, and the difference is
fundamental to the Keynesian System.

A full explanation is provided below,9 but to continue
our discussion, these two curves will intersect at some point
(E) representing an amount of proceeds(OP) and employment(ON).
In the aggregate sense, this is a point of profit maximization,
i.e. at any point to the left of E, expected receipts exceed
the minimum necessary to induce that volume of employment, and
expanding employment would increase receipts, while at any

point to the right of E, the reverse is true. E is the point

 

a greater supply will mean lower price. However, unless we
wish to introduce imperfect competition at this point (and

we don't), we should remember that the individual entrepreneur
cannot alter price by varying his output, and we are left
with diminishing marginal productivity as the answer.

9. The crux of the matter lies in the now famed Keynesian
wage rigidity. Briefly, using familiar tools, the supply
of and demand for labor should establish a wage that would
equate the two at W. The real world, however, displays a
disconcerting refusal to conform to such a neat solution.
Instead, because of various institutional factors, (see

pp. 266-269 of The Generaerheory) workers will not accept

of effective demand, and it is also an equilibrium position.
From.the point of view Of employment, however, it is an inde-
terminate equilibrium, since we have no way of knowing whether
N equals full emplyment. he have thus arrived at a theory

of output and employment determination, i.e. the equilibrium
of aggregate supply and demand. Unfortunately, however, we
have not yet penetrated the veil but only identified it.

We are now ready to draw that veil and discover what lays

behind it.

 

employment at less than the wage inelastic rate, in money

/U

Waseflate

Se D

 

 

O

Q of Employment

terms OW , for various levels of employment. Thus, increases
in N will result in constant proportionate increases in costs,
or from the other side of the fence,the proceeds necessary to
just cover these costs increases directly with N, and our supply
curve(ZZ in Figure l) is a straight line. The classical system
supposed these two curves to be coincident, so that while N in
in the Keynesian system need not be at full employment, in the
classical system it was of necessity. Theoretically, wage

cuts are capable of producing full employment under both class-
ical and Keynesian analysis of these two curves if the effects
on income, demand, the rate of interest and investment are
neglected, which according to Keynes, is what the classicists
did.

THE CONSUMPTION FUNCTION

We have discovered at this point that there are two
separate functions, i.e. aggregate demand and aggregate
supply, which must be dissected and their parts examined
if we are to obtain a knowledge of the mechanism that con-
trols each. The first (aggregate supply)'we shall dispose
Of with a quote lifted directly from Lord Keynes:

"The aggregate supply function...depends in the main

on the physical conditions of supply (and), in-

volves few considerations which are not already

familiar."

We have already discovered that aggregate demand re-
lates demand and employment (D - f(N) ) to various levels
of expected proceeds.ll We have now to ask, what are the
components of these expected proceeds? The answer is obvious
even before one has read Keynes--producers sell only two kinds

of goods: those intended for consumption and those which we

call producers' goods.12 We shall consider first the role

 

10. J. M. Keynes, The General Theory, p. 89. The aggregate
supply function has already received some discussion in this
thesis (see p. 5, footnote 8). Keynes discusses this func-
tion more fully in Chapter 20 (The General Theory) where the
employment function is considered. We shall, ourselves, be
considering it in the later chapter in this work when we are
comparing Keynes and Schumpeter. It is not unimportant, but
the greater part of Keynes work is devoted to explaining the

demand function.
11. See pp. 4 & 5 above.

12. We recognize that any distinct line between the two
is of necessity arbitrary, but this does not destroy the
idea. Producers' goods may also be called capital goods,
means of production, or, as Keynes does, investment goods.

10

of consumption, because it is the least interesting and rela-
tively the least important.

Now since aggregate demand is a function of employment
(N), that part of aggregate demand which is consumption must
also be a function of N. Our aim, however, is to discover
what factors govern the amount that is spent for consumption.
In other words we now must look not at the producer's decisions
but at the man who is buying the goods-~the income holder.
Since every level of employment (N) has a corresponding level
of income (Y), we may quite easily change our function to read:
consumption is a function of income.15

C = f (Y)
This functional relation provides the EEEEE for our next

important concept, the propensity to consume.14

 

16. This completely interchangeable character of N and Y

is open to the Objection that for all distributions of employ-
ment it will not hold. For example, if a certain employment

(N) is distributed heavily in those industries, firms, etc.,
which use a large amount of labor and a small amount of capital,
Y will be lower than those industries where the reverse is true,
because the marginal productivity of labor in the latter case
will be higher generally. However, says Keynes, (p. 90 of

T he General Theory) this money income alone would not enable
the income recipient to buy more consumption goods.

 

14. L. R. Klein, Ibid., p. 59. Klein adds the rate of in-
terest (i) to the ffifiEtion so C - f(Y,i), but admits that the
interest rate probably has a negligible effect on consumption.
Keynes includes the interest rate in his objective factors
determining the prOpensity to consume, and advances similar
reasons as to why it is negligible, but he does not include

it (i) in his functional equation.

11

For every level pf income(Y) there is a_prqpensity £2

 

 

 

spend E_Specific part g£_that income (C) on consumption.

 

 

 

What then are the factors which determine what this prOpen-

sity will be? Roughly they are divided into three groups by
Keynes: (l) the level Of income, (2) other objective circum-
stances and (5) the subjective habits of the community re-

garding the disposition of their income.15

The third group, the subjective habits, are assumed to
be fixed by custom, convention, etc., and so may be assumed
to be given at least in the short run. The Objective circum-
stances which include such factors as windfall profits and
fiscal policies are negligible in their effect though a gain
in the short run. Since these two determinants are neither
relatively fixed or negligible, we may assume that the pro-
pensity to consume is a relatively stable function.

Now since these two factors assure us of the stability
of the prOpensity to consume, we must turn to our remaining
variable, i.e. income, to answer the question of how changes
in amounts of consumption come about. We are confronted at
this point with what Keynes has called

"The fundamental psychological law, upon
which we are entitled to depend with great con-

fidence both a priori (ind)...from the detailed
facts of experience..." 6

 

15. See The General Theory, p. 91, for a list of these
factors.

16. The General Theory, p. 96.

12

This fundamental law is that as income increases, consump-
tion also increases, but by less than income. Stated another
way, the marginal prOpensity to consume is positive and less
than unity.17 The shape Of the consumption function is thus
determined and may be represented graphically as in Figure 2.

Since indhme and ouzput are, as we have shown above,
equal for all amounts, we may represent the relation between
income on the horizontal axis and output on the vertical axis
by a 45° line (on) from the origin. The consumption function
(CC) following the shape just outlined, increases with income,
but by less than the amount of the increase in income.18

It would be well to note at this point a resultant feature
of the consumption curve having this particular shape. we

can see very clearly from Figure 2 that as income increases,
say from Ylto Y2 to Yx , the distance between the income line
(OE) and consumption (CC) grows larger and larger. This verti-
cal distance, which is continually increasing with additions

to income, is the famed "investment gap", of paramount impor-

tance when we are talking of maintaining specific levels of

 

17. The marginal propensity to consume, unlike the average
propensity, is not stable but varies with income changes, de-
creasing as income increases because a smaller absolute
amount of increments to income is Spent on consumption. For
an excellent explanation of this the reader is referred to

D. Dillard, Ibid., pp. 76 to 79.

18. Some empirical attempts have been made to verify this
theoretical shape of the consumption functions: see K. Ruggles,
National Income and Income Analysigy pp. 258 and 259.

15

FIGURE 2

 

 

 

\f,

INCOME

14

income and/or employment. We shall reserve our discussion
of the so-called gap until a later point in this thesis,
but it would be well to note in passing that it derives its
nature from the fundamental shape of the consumption curve
derived from our "fundamental psychological law".19
At this point in our summary of Lord Keynes, we have
completed our examination of part of aggregate demand (con-
sumption), and we are ready to turn our attention to invest-
ment. Before we leave the consumption function, however,
we shall consider briefly the concept of the multiplier,

since it is a derivative of the marginal propensity to consume.

THE MULTIPLIER

We have mentioned changes in income, but to date we

have avoided any mention of the mechanism by which such

 

NO conclusive results have been Obtained, as is usually the
case when empirical data is used to validate a theoretical
structure, but generally Keynes's proposition at the very least
seems reasonable.

19. It might be well before we leave our discussion of the
consumption function to clear up what might appear to be a
contradiction, i.e. although we have called consumption a
stable function, Figure 2 clearly shows that it rapidly be-
comes a smaller part of income as that variable increases.
The answer lies in the difference between the average pro-
pensity and any absolute income-consumption combination.

That is, if the average propensity is .8 at an income of 100,
then 80 would be spent for consumption and 20 would be saved,
while at an income of say 200, 160 would be Spent on consumption
and 40 would be saved with the same propensity(.8). Thus

the prOpensity itself does not change, but the absolute
amounts it represents show a wide variance with changes in

income.

15

changes take place. Generally income is generated by two

types of spending: that out of the present level of income,
which in equilibrium perpetuates itself, and that spending
not out of income. It is the latter in which we are inter-

ested and we shall call it injections. Our problem is to

 

determine what effect an injection will have on the level

of income.20

If we consider the effect of putting new income in the
hands of an individual, we can see quite easily that it will
be spent, becoming income for someone else who in turn will
spend it and so on.21

To determine the limit of the rise in income that the new
expenditure will produce, we need to make use of a concept
developed briefly in an earlier part of this work: namely,

the marginal prOpensity to consume.22 The marginal propen-

 

20. Injections is preferred by the present writer over
investment or net investment, because it is more inclusive,
including such—Eipenditures as war and relief eXpenditures.
See The New Economicg, p. 482. ’

 

 

21. Economists had been aware of this for some time, but
had been unable to work out any real answer either as to
exactly how or how much, until 8. F. Kahn in "The Relation
of Home Investment to Unemployment", Economic Journal,

Vol. XLI, 1951, p. 175, worked out the theory of the multi-
plier theory in a theory of income-output determination,
since his prime concern was to determine the effects of
public works projects on income.

22. See p. 12n above. This marginal prOpensity is used
as an aggregate average of everyone's marginal prOpensity
to consume.

16

sity to consume tells us what fraction of an increment of
income will be spent on consumption. It is this fraction in
which we are interested, for the remainder which is saved

is Obviously not spent, and so does not become income.

Now the first recipient of the new income will there-
fore pass on that fraction of it (the new income) represented
by his marginal propensity to consume, and the next man will
do the same, so that the income will continuously become
smaller each time by the amount saved until it becomes negli-
gible.25

This is the way in which the multiplier works in prac-

tice, but we may also derive it mathematically as follows:

From our "fundamental psychological law", we know that
£56
43?

less than one. Let us assume that—(AS—é-is less than one by a

the marginal prOpensity to consume is always positive and

fraction—%swhere K equals the multiplier. we know income

equals consumption plus investment,so:

(2) 1 = 453—;- + .31., dividing by or,
- AC Al A1
or (5) 1 - Z"? 4- fi, since bothi. and “FY

have been defined as the

residual after consumption;

 

25. For a completely detailed arithmetical example Of the
working of the multiplier, the reader is referred to L. V.
Chandler, The Economics g£_Noneyand Banking, p. 59. For
our purposes, however, we are interested only in explaining
its nature and deriving it mathematically.

 

l7

(4)_L.= 1 _ 13C, tranSposing;
ASY
(5) K : _T_J___, multiplying by K and
— C
(SY' then byiTTigif .

 

The multiplier then is the reciprocal of OéhYminus
the marginal propensity to consumeg-é, thus if%% is % ,
the multiplier is 5; if§-% is a, the multiplier is 2, etc.
If the economy is subjected to an injection of new money,
the level Of income will be raised by some multiple of that
injection, determined by the principle worked out above.24

We shall use this principle when we assemble the Keynesian
machine and watch it Operate. For the moment, however, we
shall pass on to the discussion of the remaining component

of aggregate demand--investment.

INVESTMENT AND SAVINGS

As we have shown, consumption which constitutes one part
of aggregate demand is a relatively stable function. We now
turn our attention to the other part of that demand, and we
shall note immediately that in contrast to consumption it is
extremely volatile. For example, to use actual figures, in-
vestment in the United States dropped in the three years,
from 1929 to 1952, from 15.8 billion dollars to 0.9 billion,
or one fifteenth Of its 1929 level and within the next three

__

24. If the new income level is to be maintained, the in-
jections must be continuous, else they will quickly disappear
in leakages, i.e. savings, debt, retirement, etc.

18

years rose by more than six times its size in 1952 to six
and one tenths in 1955. Consumption for the same period, while
exhibiting fluctuations, at no time drOpped by even one half
its twenty nine level.25

It will be Obvious that the motivating variable in our
determination Of a theory of employment or output must be
investment, as soon as we have cleared up one more point.

we have Spoken, in earlier sections of this work, of that

part of income which is left after consumption as being both

investment and savings, and indeed it is both.

That is,
Y=C+S,
and
Y I C + I,
so
S = I.

The equality of savings and investment which we have
just demonstrated mathematically is, however, more than a

mere identity in the hands of Keynes.26 Their equality is

 

25. L. V. Chandler, Ibid. Figures are taken from a table
of G. N. P. presented on page 650.

26. The literature was filled with discussions of this
equality for years. The most widely accepted ways of
squaring this proposition with reality or actually with
statistics which record only what has already happened,

is the period analysis of D. H. Robertson, and the expost-
ex-ante analysis of the Swedish School, both of which say
essentially that S and I need not be identical at any one
moment, but that by looking backward after the period has

19

a condition of equilibrium, but unlike theory before Keynes
which held this equilibrium to be one of full employment.
Keynesian level of employment may be a large number of points
between a "basic" income of only consumption Spending and
full employment. The difference lies in Keynes's view of
savings. In the words Of the master himself,

"Saving...is a mere residual.27E
That is to say, in terms of a function, savings is

determined by income, (S = f(Y) )?8 and to continue,

"The decisions to consume and the decisions
to invest between them determine income." 9

These relations may be illustrated graphically as in

Figure 5. Savings (SS), as we have said, increase with

 

run its course and equilibrium has been reached, one may see
that they are equal. It is the author's belief, however, that
it is possible to prove S and I are always equal at any mom-
ent of time. Suppose at any moment of time a new injection
is made by investment, but precisely because it is new there
are no consumption goods for the new income to be Spent on.
Thus there is no increase in real consumption, but income
increases. For the moment, the marginal prOpensity to con-
sume is zero, and the new investment is completely saved.
Should consumers spend on the available goods at higher
prices, this would still leave savings albeit forced equal

to investment. As consumption goods come’on the market, the
money spent on them will create income, maintaining the
equality by raising income (the foregoing argument, with some
additions, is substantially that presented by D. Dillard,
Ibid., p. 89.)

27. The General Theory, p. 64.

28. In contrast, the classicists held savings to be a
function of the rate of interest, (S=f(i) ).

29. The General Theory, p. 64.

20

income, while investment (II) is autonomous, at least as

regards income. The only income possible with these curves

FIGURE 5

A
7

Savings and Invesfmnt

 

m---

 

‘9

S/ Y
INCOME

is that at E, where savings equal investment. It is Obvious
from the diagram that changes in income must come in changes
in the investment schedule (II).

We have eliminated savings, and so,if we are to proceed,
we must discover what it is that determines investment.
There are, in general, two major factors which govern invest-
ment: (1) the marginal efficiency of capital and (2) the rate
of interest. We shall consider them in the order named.

The marginal efficiency of capital is defined as

"...that rate Of discount which would make the

present value of the series of annuities given

by the returns expected from the capital-asset 30
during its life just equal to its supply price."

 

50. The General Theory, p. 155.

21

Three things are important within this definition:
(1) the rate Of discount, (2) the expected returns and
(3) the supply.

(1) The rate of discount is simply the procedure used
to calculate the rate of eaégngs for an asset over a period
of years, in exactly the same way that yield is calculated
on money. Thus, if an asset costing $100 yielded p10 in
returns, i.e. in.the product it produced etc., then it would
be said to have a yield of 10k, or the rate of discount that
would give the original price is 10m. The discount rate over

a series of periods may be measured by the well-known formula,

Original Price = Q + Q ..... Qn
IT+rmI ki+rm52 1+rm)n .

where Q is the earning for the period and rm is the rate of
discount, in our case the marginal efficiency of capital.

(2) In a static society all the Q's would be equal, but
in Keynes's they are not, because the yields are not those
produced in a system where future uncertainty does not exist
and returns are self-perpduating. The yields which make up
the marginal efficiency of capital exist only in the minds
of the entrepreneur who is faced with all the vague uncertainty
of the real world. They are his estimate of prospective yields

in the future and are actually nothing more nor less than a guess.51

 

51. Since present earnings are the only secure footing the
business man has for making predictions, these expectations
of future yields will be a function of present earnings and
such powers of prognostication gOOd or bad as he possesses.

22

(5) The final factor with which we must deal is the
supply price. Briefly stated, it is the price at which a
ESE capital asset may be purchased in the market.

Assembling the parts, we come out the same door as in
we went: the marginal efficiency of capital is the rate of
discount that will just make expected yields equal to supply

price. In terms of the formula mentioned above,

supply Price I Q ‘2 e e e e e
(Id-I'm) (I‘l’I'mlz (lo-I'm) 0

Changes in the marginal efficiency schedule may be brought
about by either or both of the last two factors. That is,
supply price may go up or down depending on the market demand
for capital assets. On the other hand, the entrepreneur's
expectations may be changed up or down by any number of psy-
chological factors, such as elections, depressions\fears, etc.

Expectations may.also diminish as a result of the dimin-
ishing marginal productivity of capital assets as the entire
stock Of capital increases.52

We may represent the marginal efficiency of capital
graphically(Figure 4) as below, where we see that with an
increasing volume of investment, marginal efficiency of

capital falls because of diminishing marginal productivity,

as explained above.

 

52. This is one of the reasons advanced when a theory of
mature or stagnant economics is propounded.

FIGUKS 4

(‘\
I

M¢f3~hd Efftdcmtl fictf-ldl

 

J.

Volume of Investment

The elasticity of the schedule will be important when
we come to discuss effects of changes in the rate of interest,
but for now we shall pass on to the discussion of that rate.
As a point of departure for our discussion of the theory
of interest, we might well start by stating what interest
is not. Interest traditionally has been regarded as the
reward for abstaining from present consumption--for waiting.55
In the Keynesian system, however, interest is a monetary phe-
nomgaon; it is the price established by the demand and supply
of money. People prefer money because of its perfect liquid-
ity compared to other assets, which makes it " a link between
the present and the future."34 This demand for liquidity

may be broken down into three main motives:

 

55. Interest as a reward for waiting is consistent with full
employment, where any increase in investment must be at the
expense of consumption, and vice versa.

54. The General Theory, p. 295.

24

(1) The Transactions Motive - That part of the money
supply which must be held to satisfy the everyday business
needs Of the community. This motive is a function of income,
varying directly with it.

(2) Precautionary Motive - That money held for emergen-
cies, such as illness and unforeseen accident, etc. This
motive has its roots in the uncertainty of the future.

(5) The Speculative Motive - Probably this motive is the
most important of the three. It is the motive behind the
holding of money in anticipation of a change in the rate of
interest, or more precisely, because of uncertainty as to
what is going to happen to the rate of interest.

The total quantity of money(M) will be held because of
these motives and in varying prOportions according to the
strength of each particular motive.

Graphically, the schedules for each may be depicted

55

as well as their interactions, as in Figure 5. The curve

L1 is the liquidity preference curve for the speculative motive.
It shows that as the interest rate falls, more and more money

will be demanded for idle balances.56

 

55. This graphical solution is drawn directly from that
presented by Alvin Hansen, Monetary Theory and Fiscal Policy,

p. 67.

56. This is so, because as the interest rate falls, the chance
of having a large part of the principal wiped out by a rise,
increases as the rate falls. That is, a 1% rise when the

rate of interest is 5% on a $1000 bond would mean a loss of
3250, since the same income can be bought for @750 at 4%.

25

At some interest rate (1), the curve flattens out, becoming
infinite at that rate},7 The series of curves on the left
represent the transaction schedules for cash. The precaution-
ary holdings, which are difficult to distinguish, may be
considered as being included in either schedule since they
are negligible. Keynes usually lumped them with those of
transactions.38 The transactions function is assumed to be
interest elastic only at high rates Of interest. Otherwise
it is completely interest inelastic, being purely a function
of income.

Thus at an interest rate of if the income Y1 , the quan-
tity of money, which is assumed to be fixed, is divided,
AB to transactions, and CD to the speculative motive. As
income rises to Y2, more money (a) is required for transac-
tions and is withdrawn from the speculative motive, raising
the rate of interest to 12 and so on. The process will
also work in reverse, that is, as income falls, money will
be realized from transactions and will "fly" to liquidity,
causing the interest rate to fall until it reaches the
irreducible minimum where the liquidity preference curve

flattens out.

 

57. It is argued that eventually the curve will turn back
up, for instance, when hyper-inflation sends people back

to assets, but for the range that is usually important

the principle seems sound enough.

58. D. Dillard, op. cit., p. 171.

*‘

26

 

 

 

 

 

 

 

 

 

 

 

 

 

FIGURE 5
Transactions Curve Liquidity‘Preference
Curve
’I Y r
Y; 3
Y}
+4 }
z, x
t n
a
1...)
g
H
12
11 L!
A B c ‘T/D

Quantity of honey

27

Having briefly explained the nature of interest and
the marginal efficiency of capital, we now turn to their
role in determining the level of investment. Perhaps the
easiest way Of looking at the problem is in terms of familiar
supply and demand analysis. The supply price of an asset is
the money return that you could receive by investing the
money necessary for the purchase Of the asset at the current
rate of interest.39 The demand price, on the other hand,
is the expected yield from that asset, or the marginal
efficiency of capital. Therefore, as long as demand (marginal
efficiency of capital) exceeds supply (current rate of in-
terest), investment can profitably expand up to the point
where they are equal, or if supply exceeds demand, contract
until they are equal. Investment then, is a function of
the rate of interest and the marginal efficiency of capi-
tal, and we have determined our last variable; the system

is complete.

 

59. On the basis of some empirical studies on what business
men really think Of the rate of interest (J. Franklin Bber-
sole, "The Influence of Interest Rates upon Entrepreneurial
Decisions in Business - A Case Study", Harvard Business
Review, Vol. XVII, 1958, p. 55 and H. D. Henderson, "The
Significance Of the Rate of Interest," Oxford economic

Pa ers, NO. l, 1958, p. 1), it would seem that it may not

he a significant variable at all, especially in short run
investment projects and decisions. If this is so, some
other cost function might be used to replace interest, or it
may be that it is not costs but returns that are looked at

by investors.

28

Before we begin our discussion of the system erected
by J. A. Schumpeter, let us very briefly put together the
parts of the Keynesian system we have assembled. Our problem
was to provide a theory of output determination, and we found
that its determination was the result of the intersection
of aggregate demand and supply, according to the principle
of effective demand, Aggregate supply we discarded as being
determined mostly by familiar conditions of physical supply.
Aggregate demand was found to be made up of two types of ex-
penditure, consumption and investment. Consumption, the stable
function, was determined by income, while investment, the
vofiitile function, was determined by the relation of interest
and the marginal efficiency of capital. Investment so deter-
mined, operated through the principle of the multiplier to
give a determined level of output. If we understand that
none of the equilibrium levels of output possible under this
system are necessarily full employment levels, then we are
ready to leave the Keynesian system for the moment and begin

the description of Schumpeter's work.

CHAPTER II
THE SCHUMPETERIAN SYSTEM

The name of Joseph Schumpeter is usually associated with

his momentous two volume treatise, Business Cycles. To the

 

uninitiated, the Schumpeterian contribution is usually vaguely
considered to be a theory of innovations as a prime cause of
the business cycle. Keynes, too, is thought of in the same
vein as having posited another theory of cycles in terms of
investment gaps. Actually, the primary work of neither man
was devoted to a theory of the cycle as such. Keynes, as we
have shown, was interested in a theory of output determination.
Schumpeter was interested in developing a theory that would
explain economic change. It was only incidentally that either
developed a theory of cycles, or perhaps one might say, con-
sequently. In support of this argument we may offer Professor
Schumpeter's own words in the preface to his Business Cycles.
"Analyzing business cycles means neither more nor
less than analyzing the economic process of the capitalist
era. ...I have called this book "Business Cycles" in

order to indicate succintly what the reader is to eXpect,

but the subtitle really renders what I have tried to do."1

 

l. J. A. Schumpeter, Business Cycles, the first paragraph
in the Preface. The subtitle reads A_Theoretical, Historical
and Statistical Analysis g£_the Capitalist Process.

50

We make this point at the very beginning in order that
the reader may quickly discover that our primary interest
will not be in the area of the trade cycle but rather with the
system Schumpeter has erected. With Keynes we took as our
main source his General Theory g£_lnterest Employment and
Mgngy, and so with Schumpeter we shall use chiefly his
The Theory of Economic Development. It is this work which
preceded the classic BusinessprclesL and which contains the

2

pure theoretical model, in which we are interested. Busi-

ness Cycles is an extension and enlargement of this earlier

 

work, coupled with a tremendous attempt to verify the model
established in the earlier volume. we shall not neglect the
latter book, but shall place our main reliance on the former
for the reasons just stated.

THE CIRCULAR FLOW

The foundation stone on which all later refinements of
Schumpeterian thought is founded is that of the circular flow
concept of economic activity.5 First, as to the milieu in
which the concept is operative, we shall posit a commercially
organized state in which private prOperty, division of labor,

and absolutely free competition prevails.4

 

2. Business _ycles was published in 1959, The Theo_y of
Economic Development(Theorie der wirtschftlichen Entwicklung),
German edition was published in 1911 with the English edition

appearing in 1954.

 

 

5. We shall only outline the concept briefly here. For a
fuller eXplanation the reader should see Chapter I of The
Theory of Economig_Develgpment.

4o 3.2.219." p. 50

51

We have first to consider the psychological or mental
basis on which decisions within such a state might be for-
mulated. For brevity's sake, we shall use Schumpeter's
example of the farmer as our own, with the understanding
that it applies to all members of the society--businessmen,
laborers, etc. We shall ask, how does our farmer know, When
he is raising his crOp, that consumers will want the bread
manufactured from his grain and in what quantities? The answer
is as simple as it is obvious: experience, his own, his father's
and his father's before him has given him the requisite know-
ledge. Moreover, he finds that in every period he must live
from the proceeds of the previous period, and

"All the preceding periods have, furthermore, entangled

him in a net of social and economic connections...means

and methods of production...éwhich) hold him in iron
fetters fast in his tracks."

From the preceding flows our first major premise, if
we extend it, as we have said, to all members of the society.
This premise is that everyone lives during each economic
period on goods produced in the preceding penbd. The process
is continuous, and we see that circular flow is descriptive
of the process whereby factors of production flow into the
production of goods which become the income or payments of

goods for the next period, and so on. Every producer of goods

acquires the means to purchase exactly the amount of goods

5. Ibid., p. 6.

52

he has produced, and he does so. In short, supply creates
its own demand; Say's Law is in full operation.6 This does
not mean that we have eliminated change in our system, for
the underlying data in which that experience is founded may
change, and all will alter their behavior to correspond with
the new data.7 Such changes will, however, come about slowly,
for they must break the frozen bonds of habit.

...the economic system will not change capriciously

...but will be at all times connected with the pre-

ceding state of affairs..."

Neglecting, for the purposes of abstraction, the changes
Just mentioned, we have a state in general equilibrium in the
Walrasian sense. All the firms within our system are, in
long run perfect equilibrium, and profit is nonexistent.
If profit exists it is because there are imperfections or
frictions existing, and we have not arrived at full equili-
brium. The argument is well known. If profits are to be
had, then new firms will enter, and producers will expand
production until increased supply and increasing costs wipe

out the profit margin, at which point it will not be profit-

able for the producer to alter his position.

 

6. There is one important difference: the flow of savings
into investment automatically regulated by the rate of interest
is not at work here, because, as we shall see, interest does
not exist and savings are not of the type envisaged by Say.

7. Changes in consumers' taste patterns, etc., may be consi-
dered an example of a change in the underlying data.

8. Ibid., p. 9. This is Wieser's principle of continuity.

55

Having arrived at general equilibrium, we may well ask
by what principle the total product of the economy is divided,
and to whom it goes. We may discover to whom the national
income will go if we trace the hierarchy of goods, i.e.
consumption, to producers, to heavy production, and back
to its ultimate fountainhead. There we discover that

"We can resolve all goods into 'labor and land'

in the sense that we can conceive all goods as

bundles of the services of labor and land."9

In other words, all godds are the products of either \r'

_—-'

labor or land, or some combination of the two. It is in-

teresting to note here that the production coefficients which

 

represent the quantitative relation of these two prime factor

to a unit of output are subject to change without changing w]
the method of produCtion. This is true to the extent thatww

the two are substitutable for each other.10 For instance,
mechanical power may be used to displace labor, or vice versa,
without changing the end product. This is the key to explaining
how it is possible for the economy to shift factors within
itself without changing its equilibrium position. It is pos-

sible then, for the forms the goods take to vary somewhat

 

9. Ibid., p. 17.

10. Schumpeter makes it clear, however, that the production
function which is economica11y_best may not be that which

is technologically superior. Thus we have more Fords and
Plymouths than Cadillacs, because the former are economically
the best. The production coefficient is more commonly known
as the production function, Which we shall discuss when
comparing Schumpeter and Keynes in a later chapter.

54

without changing the method of production nor the equilibrium
position. In general, however, we may assume that more or
less identical goods are turned out each year, the production
coefficient being determined by each firm on the basis of long
experience in deciding what the public will buy, and how it
may be best produced.ll

Having discovered the two prime factors (labor and land),
we may now prodeed to examine the manner in Which the total
social product is divided between them. as we have already
shown, profit within the circular flow does not exist, and
therefore costs are just covered by receipts. Labor or land
will receive as its payment then, that share contributed by
its least important, or marginal unit, and the payments to
both must just equal the social product.

We may illustrate diagrammatically, as in Figure 6, where
the amount of labor is measured on the horizontal axis and
the amount of land on the vertical. At any one point, say
0A, the marginal productivity of labor indicated by the de-
clining curve(Xm is equal to AB, and the wages of all workers
are equal to the rectangle (ABCO). The residual (CDX) must,

as shown above, be the return to land which we shall call rent.

 

11. The concept described above might be more clearly
understood if it is linked with J. B. Clark's (The Distribu-
tion of Wealth, Chapter IX) conception of capital. Although
capital as such has no place in the circular flow, the idea
is similar in that we conceive of the social product as an
abstraction Which is continuous and unchanging. The material
forms from which the abstraction arises, however, are subject
to a fairly wide variance.

+4
U
3
‘8
at
‘3 Rent
Tn
1;, w
a w .
G k B
Wages
0‘ A

55

FIGURE 6

 

 

 

 

Quantity of Labor

56

Similarly, we might consider the return to land first, leaving
rent as the residual without changing the outcome.

From the foregoing analysis an important implication
emerges. Since capital is not a factor of production, then
interest, the return to that factor, does not exist--it is zero.
Capital goods are transitory items which involve no independent
value formations and receive no income as such. Zero interest
will not seem so strange if we remember that in the circular
flow there is no waiting and no uncertainty. Production is
synchronized with consumption in the continuous process of the
flow as we have described it earlier. 12

Two more results of the above type of analysis are worthy
of mention before we pass on to other topics. First of all,
money in this circular flow receives its value only from the
real goods it can purchase. It is a 'pure' medium of exchange.
The holding of money in idle balances for purposes other than
exchange is completely unnecessary}:5 Secondly, no capitalists
are present in the system, because there is no capital receiving
returns as such. Entrepreneurs are "entrepreneur(s) faisant
n; bénéfice n; p§§t§,"14 whose function is simply direction,
and whose income is included in wage. If by chance they own

the means of production, then they receive rents as well as wages.

 

12. See A. Achinstein, Introduction 32 Business Cycles, p. 458.

150 SChIlmpeter, Ibid., p. 550

14. The phase is attributed by Schumpeter to Walras. See
The Theory pf Economic Development, p. 46.

 

57

Briefly then to summarize the concept of the circular
flow, we have found that it is a continuous process, eliminating
capital as a factor and interest as a payment, because production
and consumption are considered to be perfectly synchronized.
The roundabout method of production, which gives to capital a
value and to waiting a payment(interest), is non-existent.
Finally, we may note that the money is a passive medium of
exchange only, and the entrepreneur is a simple director.

INNOVATIONS

It is quite obvious that the state in perfect equilibrium,
which we have established with the circular flow, is not an
accurate picture of the real world. It is possible with our
model to examine the new equilibrium position reached after
normal changes in the data of the system have worked themselves
out, i.e. pOpulation growth, changes in consumer tastes, etc.,
but we are unable to eXplain, however, the occurrence of pro-
duction revolutions, the building of a railroad, or, inshort,
changes in the data which occur by fits and starts. These changes
in the data, Which have their origin in sources outside the
economic system, we shall call development. To define develop-
ment we turn to Professor Schumpeter's own words.

"It is Spontaneous and discontinuous change in the

channels of the flow, disturbance of equilibrium,

which forever alters and displaces the equilibrium
state previously existing."1

 

15. SChUlnpeter, Ibid., p. 640

38

These developments are assumed to be initiated, as a
rule, by producers and not consumers. A change originating in
consumption we shall consider, for the most part, as being a
change in the underlying data. For such a change, the static
analysis of the circular flow is adequate. Since the producers'
main function is the combining of the factors of production,
we further define development as the making of new combinations
of these same factors by the producer. Moreover, these new
factor combinations are not of the type that gradually occur
in any production process, but are sudden and drastic recombi-
nations which appear on the economic scene discontinuously.
These new combinations we call innovations, and the following
five types of such changes are considered to be inclusive:

(1) the introduction of a new good or a new quality within

an old good; (2) the introduction of a new method of produc-
tion not necessarily related to technology, for it may occur
in new methods of distribution or marketing; (5) the opening
of a market new to the industry concerned, even though this
has previously existed; (4) the acquisition of a new source
of supply, regardless of whether it has previously existed or
is newly created; (5) the carrying out of a new organization
of an industry, whether it means creating a new structure or

displacement of the old.16

16. Schumpeter, Ibid., p. b6. The concept of innovation
has been open to a good deal of criticism from prominent
economists. The discussions of these argtlments.advanced

 

59

Two assumptions are necessary at this point to clarify
the manner in which these innovations work themselves out in
the economic system. First, we assume that as a general rule
the new combinations are carried out by new firms which do not
arise from old firms, but rather exist beside them. This is
important in explaining the elimination of old firms, the rise
and fall of families (moneywise), and the general chaos that
seems to attack the personal fortunes of the people who make
up an economy during a business cycle.

Secondly, we assume that at the time the new combination
takes place, the economy is operating at full employment.

That is to say, there are no idle laborers, no unused raw

17 If it is remem-

materials, and no idle productive capacity.
bered that we are still starting from the theoretical circular
flow, such conditions will not seem unduly artificial, since

full employment is a characteristic of such a flow.

 

against Schumpeter's concept have no place in this chapter,

but the interested reader is referred to the following sources.
Concerning the problem of definition, see J. W. Angeli,
Investment and Business Cycles and S. S. Kuznet's "Schumpeter's
Business Cycles? American Economic Review, June 1940. For

a discussion on whether the concept is too broad or too narrow,
see 0. Lange, "A Note on Innovations," Review 9f economic
Statistics, February 1945 and w. w. Rostaw, British Economy

9f_the Nineteenth Century, p. 29.

17. In real life such unemployment quite obviously does exist,
and would be a favorable condition to the emergence of new
combinations. However, such unemployment is the result of the
very development we are trying to explain, and to admit it at
this stage of our analysis would be to place the cart before

the horse.

40

The next step in our chain of reasoning follows logically
from this second assumption. The firms which are already
operating within the Circular flow have no trouble procuring
the means of production, for they have, as we have seen, the
proceeds from the previous period, which are just equal to their
needs. The working of the mechanism is automatic and perfectly
synchronized, as we discovered when we examined the circular
flow concept. The new firm is in quite a different position.
Not only does it not have the proceeds from any previous pro-
duction to secure the necessary factors, but those factors are
completely employed by the old firms. how then do we resolve
the dilemma? The answer is credit, for only thus may the
entrepreneur who is about to begin a new combination secure
the necessary purchasing power under the conditions we have
imposed. In traditional theory, as we have mentioned, savings
were the chief source of investment funds, but in our circular
flow they do not exist except as the realized proceeds from
previous production, and they are exactly equal to the amount
necessary to maintain this equilibrium position. No surplus
or extra funds are available, then, except as credit creation
shall provide them.

There are, in general, two sources of credit upon Which
entrepreneurs may draw. The first, and most obvious, is the

banks. Under fractional reserve systems it is possible for

41

them (the banks) to create new money.18

That this new money

has no relation to past production and no real backing,in no

way diverts its equal command over goods with money previously

existing.19
The second source of credit is the profits accumulated

by previous innovators, but since we have as yet not explained

the process whereby they acquire these profits, we shall only

mention this possibility here as existing. By introducing

the concept of credit into the Schumpeterian system, we have

made a place for a familiar figure which we have up to now

excluded--the capitalist.2O

It is his function to provide
this credit, and it is only this function which gives him a
place in our society.

It remains to describe the entrepreneur, who is the in—
novator, before we may pass to another topic. he is, most
of all, a man who has the vision to see the possibilities in

a new method and has both the courage and the ability to attempt

to introduce his idea into a hostile world. Unlike our entre-

 

18. This is the most important way of creating new money,

but any method, e.g. bank acceptances, which create new pur-
chasing power, even though this purchasing power is fully backed
by securities which are not circulating media, may be considered
as credit. See Theory 9: Economic DevelOpment, p. 75.

19. Except as price rises reduce its 'real' value.

20. If the reader will withhold his criticism of this defi-
nition until our discussion of capital, the matter will be

a little less open to diSpute. It is this function also
which makes us a capitalist society as differentiated from
an exchange economy.

42

preneur of the circular flow, he is not a mere manager or
director who repeats the old ways continuously, but rather a
brave knight who strikes off alone into the wilderness of new
and untried methods. It is to be hoped that in attempting
to distinguish the innovating entrepreneur from his circular
flow counterpart, we do not paint a picture of superhuman
genius. To balance the picture and perhaps clarify it some-
what, we shall close our brief description of the innovator
with a quote from Schumpeter.

"...these people are by no means looked upon as parti-

cularly rare birds. All we postulate is that that

ability is distributed as unequally as others are

and all we hold is that this fact has an important

influence on the mechanism of economic change."21

PROFIT

Entrepreneurial profit in the Schumpeterian system is,
at least in definition, no different from any modern business-
man's version of the same thing. That is to say, profit is a
surplus over cost or the difference between receipts and out-
lays. It is in the explanation of the origin of this surplus,
and the reasons for its accruving to the entrepreneur only, that
we will mark the departure from traditional theory and get at
the roots of Professor Schumpeter's concept.

Let us examine the introduction of an innovation to see
if we may discover where in the process profits arise. we have

first to impose three conditions that are necessary, both for

 

21. A. Schumpeter, Business Cycles, p. 150.

45

the new combination to be properly classified as an innovation
and for profit to appear. First, the price must not fall
when the product, which is the result of a new combination of
factors, first appears on the market. If the price does fall,
it must not be to that level where receipts just equal costs.
Secondly, the new production function, in terms of input costs,
must be below that of the old output, remaining the same or
increasing.22

The third condition is contingent upon the rise in prices
that will be brought about by the new firm bidding factors of
production away from the old. This rise in prices must be
anticipated and included in the entrepreneur's costs if our
third condition is to be fulfilled. When and if these three
conditions are realized, then a surplus of necessity must

be produced which is a net profit. Such a surplus will occur

if the above conditions are fulfilled, even in a socialist or

non-exchange economy.23

The solution, when the three conditions are fulfilled,
is depicted graphically in Figure 7. The cost curves of the
old firms are represented by the solid lines (MC and ATC), and

the price is OT. The firm is, as we have noted, in equilibrium,

 

22. Schumpeter does not use the production function in ex-
plaining the second condition, but we have introduced it here
because we wish to make use of it in a later chapter.

25. While it is true that in such economies the surplus will
probably not accrue to the leader but be divided among the
other factors, nevertheless the surplus does arise.

45

and costs are just covered as indicated by the tangency of the
average total cost curve to the average revenue curve (PPl) at
R. The innovating firm's cost curves are represented by the
broken lines (MC and ATC). The shaded area (PEST) represents
the total profit as long as price remains at OP. Some profit
would obviously be made with the cost curves shown, as long

as price remains above OT.

It has been objected that these three conditions, which
we have cited as the conditions for the introduction of the
most common type of innovation, rigidly limits our concept of
innovation. To quote Professor Kierstead,

"This emphasis, we might note, implies that Professor

Schumpeter...always thinks of it(innovations) as the

introduggion of new-and less costly ways-of making old

goods."

The criticism is certainly not valid, as anyone may verify
for himself by consulting The Theory pf Economic Development.25
The type of innovation we have developed is perhaps the most
obvious and quantitatively the most important, but Schumpeter
also deveIOpes other important types, including the substi-
tution of one good for another, an increase in quality, new

markets and completely new goods.26

 

24. B. S. Kierstead, Theory of economic Change, p. 95. Italics
mine.

25. See particularly pp. 54-157.

26. See The Theory 9: Economic Development, pp. 154-155.
In real life of course many of these innovations are carried
out by old firms, but for the sake of clarifying the process
we are describing, we have eliminated this possibility.

 

46

Having briefly outlined the process whereby profit appears,

we have now to answer the question of why this profit should

be diverted to the entrepreneur. The first and most obvious
reason is that without the innovator, the surplus would not

have arisen. He may be considered, for the moment, a third
primary factor of production. Secondly, we may answer the
question indirectly by showing why it dgg§_ng§ go to the two
original factors, labor and land. Their value is determined

by what they could receive in alternate employments. Hence

in the new firm they will receive no more than in any other

firm in the system §t_the time the innovation i§_introduced.

 

 

We have shown, however, that in the new firm less of the factors
are employed, or those employed produce more, so that there

is clearly a surplus but one to which they have no claim.
Finally the factors other then entrepreneurship may be inter-
changed, i.e. labor may replace machinery and vice versa with-
out change in the end result, but all would be lost if the
entrepreneur were removed.

The profit will, however, not be permanent. Once the
innovation has begun, immitators will flock to the band wagon,
and the press of competition will eliminate the surplus sooner
or later. As the new combination becomes more and more common,
the entrepreneur loses his unique position and becomes replace-
able. He then returns to his status as a labor factor, and the

total proceeds are once again directly imputable to the original

factors--we are back in equilibrium.

47
INTEREST

Because we wish to examine the theory of interest in more
detail in the following chapter,we shall attempt here to pre-
sent only the bare outline of the complete theory. As we have
‘seen in the circular flow, interest does not exist, and so we
assume that it is connected with development. Further we have
discovered that the surplus produced by deve10pment accrues to

27 Interest must,

the innovator as entrepreneurial profit.
therefore, flow from this profit, since there is no other ,
surplus in existence. Interest is a permanent income, and as
we have shown that the entrepreneurial profit from any one

innovation does not endure, it follows, then, that interest

 

does not flow from any one surplus but from a class or series
of such surplus. Neither is it possible to attach interest to.
any concrete factors of production, for, as we have seen,
they do not normally give rise to any returns over those going
to the original factors of production. The above does not
mean that profit and interest are identical, but only that
profit is the source from Which interest flows.

We have still to ask ourselves Why interest must be paid.
We know that if entrepreneurs had in_their own hands the power

to command the producers'.goods they require, entrepreneurial

 

27. Some profit also goes to old firms because of price rises
brought about by the income created by the innovating firm,
but since this is simply induced profit, we may ignore it.

48

profit would exist, but there would be no reason to pay interest
to anyone.28 The entrepreneur does not ordinarily have the
means, in his own right, to acquire the factors he needs, as

we have shown earlier. It is necessary for him to turn to

the capitalist who removes the obstacle from the innovator's
path by a loan. In accord with the nature of things, however,
he does not make such loans out of a desire to see the system
develops. He requires a payment for the use of his capital,

and this of course is interest.

purchasing_power re arde fig §_means pf contrBI
over production goods.

While it was not possible to introduce any time-preference
in Professor Schumpeter's original static state, we may, with
the aid of the two concepts just developed (profit and interest),
do so now. If an entrepreneur expects that his innovationwwill
yield him a profit when it is completed, (and why else sould
he innovate) then present money, to secure the means of pro-
duction, will have a greater value than future money. He
will, therefore, willingly pay the present premium (interest)

to secure that money.

 

28. This is the argument advanced on p. 177 of The Theory
of Economic Development, and Schumpeter adds that neither
would there be any motive for the entrepreneur to consider

any part of his profits as interest on the capital he has
expanded. This seems, to the present author, to be true only
if it is not possible for the entrepreneur to invest his means
of production in an alternate method 32 interest.

 

29. The Theogygf Economic Deve10pment, p. 184. Italics
Schumpeter's.

 

49

We shall conclude our brief remarks on interest by adding
that interest is, as we have demonstrated, a monetary phenomena,
and the rate of interest is determined in the money market
according to the familiar law of supply and demand.50

CAPITAL

It remains to outline our theory of capital for the pic-
ture to be complete.51 We have already indicated that it is
the capitalist's function to provide the entrepreneur with the
necessary purchasing power to withdraw from the circular flow
those factors of production Which he needs. We might add that
it is precisely this function of capital Which distinguishes
the capitalist economy from other forms, where such control
over the factors is secured by command or mutual agreement.
This is the gnly function of capital and its raison d'etre
in the economic organism. In the circular flow it would not
exist. It is purely a product, then, of the one causal factor
we have admitted to the system-~namely, develOpment.

It follows from this that capital does not consist of any
definite category of goods, either producer or consumption goods,

for both existed in the circular flow where capital was not to be

discovered.

 

50. Ibid., pp. 192-1950

51. Ordinarily we should, after explaining the theory of
deveIOpement, proceed to outline the part it plays in Schum-
peter's business cycle theory. Since, however, we did not so
include Keynes's theory of the cycle, we shall postpone this
discussion to the last chapter, where we will compare the two

theories.

50

This is, and of itself should be, sufficient grounds for
believing that capital is not grounded in any one class of
goods. The argument may, however, be extended beyond the static
state. From the standpoint of the entrepreneur, all the goods
he needs to carry out a new combination are on the same level.
That is to say, he needs labor, land, machinery, new materials,
and so on. There are, of course, real physical differences
in the items he will need, and there are also differences of
magnitude as regards each type of good, i.e. he may, perhaps,
need more laborers than machines, or more land than both, etc.
No one good or class of goods is of any use to the businessman,
however, without their econcomitant brethren; he needs them all.
The argument is not damaged if the producer first buys one
definite type of good in order that he may then procure the
others. For example, he might acquire consumption goods which
he could exchange, as the situation required, to secure the ser-
vices of labor or land. The significant point to be made is
that he does buy these goods with money for which hg_p§y§
interest.

Capital, therefore, is not goods, but rather command over
goods.

"Goods are bought for capital...but this very fact

implies the recognition that is function is different

from that of the goods acquired...It(capital) stands

as a third agent necessary to production...between
the entrepreneur and the world of goods.“52

52. The Theory of Economic DevelOpment, p. 117. Italics
Schumpeter's. _—

 

 

51

Once he has exchanged the fund of capital which he has
presumably borrowed, are not the goods, which he has acquired
at this point, his capital? We must, says Schumpeter, answer
in the negative. 'The entrepreneur has spent his capital, and
he has now only a stock of goods. Indirectly it is possible,
however, to consider these goods as capital or, perhaps more
precisely, potential capital, for the owner may sell them in
the market. He will again find himself in possession of capital
This argument would seem to highlight our definition. It was
not the goods, but the money he received for their sale, Which
is, in our sense, capital.

Capital then is a fund of purchasing power; but is all
purchasing power capital? Again we must answer in the negative.
We know that in the circular flow there exists purchasing power
(money), but it is simply a medium of exchange and nothing else.
It facilitates exchange, but it is not essential to it, i.e.
presumably it would be possible to carry out transactions without
the aid of money, although it would be admittedly extremely
clumsy. It is not so in the carrying out of new combinations,
as we know, for the command over other goods is essential. We
come therefore logically to our final conclusion. Capital is a
concept connected with development and only development. It is

"...that sum of means of pgyment which ig available

g§_any moment for transference £9 entrepreneurs.”5

 

55. Ibid., p. 122. T he form capital takes may be quite varied,
i.e. money, credit, promissary notes, the limiting condition
being that it be used in the carrying out of some innovation.
Italics Schumpeter's.

52

we will end our remarks on capital by noting that in the
Schumpeterian system there is no social capital, for all forms
of capital are only performing their real role When they are
being used by private entrepreneurs engaged in carrying out
an innovation.

We may now briefly outline the Schumpeterian system as
we have presented it. First of all we postulated a static
state in which there were only two prime factors of production,
labor and land. Cost just equaled receipts, with all income
going ultimately to the factors just named. Production in our
circular flow was periectly synchronized with consumption, so
that there was no such thing as time preference, and consequently
no interest. Innovations, which in the most general case
lowered cost curves, upset our equilibrium position and made
entrepreneurial profit possible. To secure the means of pro-
duction we introduced capital and its payment, interest.
Capital, we discovered, was not a concept vested in concrete
goods, but merely the means of acquiring those goods, usually
money. Finally we noted that ceterus paribus competition from
a flock of immitators would reduce the innovator's profit

margin to zero and restore our system to equilibrium.

CHAPTER III

THE PARTS COMPARED

Before we begin our discussion of the Keynesian and
Schumpeterian schemata, it would be well to clarify our
method of attack. This section of our work is devoted to a
comparison of the individual parts of the two systems. we
have selected what we considered to be four of the most
important of these parts: the rate of interest, the theory
of capital, unemployment, and the theory of prices. This
list is not inclusive, but we hope it has covered enough of the
fundamental concepts to give the reader some idea as to the
similarity of the two systems, in both approach and results.
We have tried to escape the pitfall of 'forcing' our comparisons,
of trying to make loose ends fit when they in fact do not.
We doubt that we have been blameless in this reSpect. Any
errors in either analysis or the conclusions reached must be
laid at the writer's door. We have stated, with each concept
compared, our own opinion regarding their similarity. When-
ever possible we have also interjected the opinions of others,
and if we disagreed we have tried to show why. we ask the
reader to reserve judging our conclusions until the overall

reviews of both systems have been made in the final chapter.

54
THE RATE OF INTEREST

As a point of departure for our comparison of the rates
of interest developed by these two men, we shall utilize a
statement in an article written by H. M. Goodwin, wherein
that gentleman dismisses our problem in a very cursory manner.

"He (Professor Schumpeter) cannot, however, be

classified with Lord Keynes, in Spite of the

fact that both take the monetary approach to
interest problems."1

We thus establish the first, and what Mr. Goodwin con-
siders to be the only, point of contact between the two
theories. Mr. Goodwin's proof, although not stated, apparently
stems from remarks made by Schumpeter in Business Cycles.

"In Mr. Keynes's The General Theory of Employment,

Interest and Money, 1955, the reader finds also a

monetary theory of interest which in some points

agrees with the one above submitted and in others
differs from it."2

If we may take the above statements as authoritative,
then we have to begin with at least one similarity, namely,
that both writers (Keynes and Schumpeter) regard interest
as a monetary phenomena.5 We may now ask ourselves exactly
what we mean when we say interest is a monetary phenomena.

1. H. M. Goodwin, "Keynesian and Other Interest Theories,"

_Hgview of go ngmic_Sta_istics, Vol. XXV, 1945, p. 6n.

. . --..I.. M m',

 

2. Business Cycles, p. 127.

5. On the surface such a concept is not new, being probably
as old as Adam Smith. What is meant, however, is that the
rate of interest is 'real' money phenomena, not tied to under-
lying productivity as it is in Bbhm Bawerk, for example.

The most obvious, and at the same time superficial, answer
is that interest is a price of money. In both the systems
examined, we know this to be true. In Keynes, interest was
the price paid for liquidity, or stated another wg', the price
necessary to induce the holder to part with liquidity which,
generally speaking, was money. In Schumpeter's Pure Model,4
interest was the price paid to the capitalist in order that
the entrepreneur might be thus enabled to bid factors away
from old firms.5 We may carry our analysis a step further
by investigating the manner in which these respective prices
are determined. We shall consider first the Schumpeterian
method, as outlined in The Theory g§_Economic Develgpment.6
First of all we postulate that any normal person values
his stock of money, and changes in his stock of money, according

to the goods he may exchange for it. The evaluations are

 

4. By Pure Model we mean that concept of the circular flow
Which we sketched briefly in Chapter II. Actually this is

only a first approximation to the Whole system which Schumpeter
'builds' through three approximations, dropping at each suc-
cessive step such assumptions as take the model away from
reality. We shall have more to say along these lines when

we compare the cycle theories of both men.

5. Money includes checking deposits, savings deposits, etc.
It is interesting to note that while for each system money

is the medium.used in both, the principal behind interest
would not change if money were non-existent. In the Keynesian
system people would find some other commodity that satisfied
their desire for liquidity, and in Schumpeter's world some
other means would be found to withdraw factors from old firms,
and presumably some payment corresponding to interest would
still be paid in both systems.

6. See The Theory 2E Economic Development, pp. 192-195.

 

56

subjective, and we may derive a utility curve for varying
quantities of money for each individual.7 By adding these
utility curves for all individuals, we may derive a curve for
society as a whole. If we consider varying rates of interest
as the payment necessary to offset the surrender of varying
quantities of money, then we may derive a supply curve similar
to that in Figure 8a. This curve represents the potential
supplies of money that might be offered on the money market
at various rates of interest.

Now on the demand side of our picture we have the entre-
preneur Who wants to borrow funds to begin his innovation.
He will be ready to offer in payment for that money an amount
equal to the marginal increment of profit he will gain by
employing the funds in his business. Now there will be some
entrepreneurs Who expect a very high marginal return, and who
will,therefore, be willing to pay a high rate of interest. As
the interest rate falls, however, more and more entrepreneurs
whose profit expectations are lower will enter the market for
money, and our demand curve will slope downward to the right
(DD in Figure 8a). At the intersection of the two curves (R),
the rate that will prevail is established.

In the Keynesian system, on the other hand, the quantity
of money is assumed to be given and may be represented by MN

in Figure 8b. The supply curve here represented is interest

 

7. Presumably such a curve would exhibit the same diminishing
utility as that used for other commodities.

Rate
of

rl
Interest

Rate
of
Interest

57

FIGURE 8a

   

 

 

M
Quantity of Money

FIGURE 8b
{N

 

 

 

 

Quantity of Money

58

inelastic; it is assumed to be a constant, determined by the
monetary authorities. The demand curve (LL) is not, as with
Schumpeter, a demand by entrepreneurs for funds to begin new
enterprises, but rather it is the demand by all individuals
for idle balances at varying rates of interest. At first sight
there would not seem to be any similarity between the two systems.
There is, however, another way of looking at the deter-
mination of interest which receives some support from Professor
Schumpeter.8 We discovered the source of interest to be profit,
but once we admit interest into the system, its spread through-
out the system is rapid and complete. The present premium,
once established, becomes a cost factor for everyone including
the entrepreneur. This is because money.is, of necessity, at
one moment of time, all of the same type. Therefore, in order
to stay where it is (new firms or old), it must continually

"...resist a pull toward the money market, which at
the margin is measured by the rate of interest."9

If we assume that at g_given ppint g£_timg_there is ex-
isting a definite quantity of money, which includes the amount
banks have created and technically could create on the basis
of the reserve ratio, also existing at that time,10 then our
supply curve for savings becomes identical with the Keynesian

supply curve, i.e. it is interest inelastic.“

 

8. Business chles, pp. 607-608. The following paragraph
is drawn from these pages.

 

'9. Ibid., p. 608.

10. This seems logical enough, assuming that banks are willing
to eXpand the money supply to the technical limit, which is

59

In place of the demand curve we have derived, we sub-
stitute a Wicksteedian demand curve which refers price (interest
here) not to that quantity of any commodity that buyers will
take at that price, but to that quantity and the quantity
which owners themselves keep. For example, if a seller held
100 units of A and offered 80 of these units at $10.00 per
unit for which a buyer was found, then demand would not be the
80 units actually bought but also the 20 retained by the
owner, or 100.11 On the basis of this type of demand curve,
we may view all money as being offered on the money market.
Part of this money, however, is taken from the market by the
owner himself. To determine how much of the available quan-
tity of money is retained by the owner, we need only have
reference to the liquidity preference curve of Figure 8b.

The curve, by definition, tells us exactly what quantities of
money peOple will want to hold out of a given stock at various
rates of interest. The two theories when regarded in this

fashion are exactly alike.12

 

the reciprocal of the reserve ratio, since this would actually
be the amount available. Even if this were not the case, it
is simply a matter of defining the expansion they would permit
to achieve the supply, adding, of course, the money already
created.

11. In Figure Be, as we originally explained it, demand would
be 80 in the above example.

12. At this point the argument ceases to follow that outlined
by Schumpeter. Ibid., pp. 607-608.

te
f
terest

c

n

60

If we wished to discover what quantities would be avail-
able to entrepreneurs at_this fixed point in 52mg, and with
a quantity of money (on), we may derive a supply curve for
such funds from the liquidity preference schedule. Thus the
liquidity preference schedule (LL), below in Figure 9, tells
us that at an interest rate r0, a quantity roawould be de-
manded for idle balances leaving 32 free to seek a buyer on
the money market.15 Similarly, at an interest rate r1, a
quantity rlb would be held, and bb_would seek a buyer, and
so on.

FIGURE 9

Money Market Li‘lUi‘UW Preference

S

 

 

 

 

 

 

N

a
*b-
-c-
‘6"
tnry-.L

 

 

 

\r

 

 

Q of Funds Offered Q 0f flow-W

 

13. The liquidity curve used here includes sums demanded
for the transactions and precautionary motives.

61

Have we then proven that the two theories are in reality
one in the same? Not according to the originator of the
theory of innovations.

"Thus we meet, for a moment and under very restrictive

assumptions, the concept of interest which has, in the

General Theory of Employment, Interest and Money, been

adepted by Mr. Keynes. But the point of tangency between

our argument and his is not more obvious than the diver-
gence of the curves."14

Before we agree or disagree with Mr. Schumpeter, let us
examine these "very restrictive assumptions" which he mentions.
If he is right and the similarity between the two systems 3
forced upon his system, then the identity must be regarded
as being at most superficial. What then are these assumptions?

Unfortuantely Professor Schumpeter neglects to list them '
explicitly, and so it is necessary that we state what in 22;
Opinion they are. We shall do this by taking the inferences
and implications present in the argument presented by Schum-
peter in Business C cles,15 from which the argument presented
earlier was drawn. To begin with we extract a quote from that
argument.

"...for the moment and for the purposes of illustration
only, we assume that there is such a thing as a definite
quantity of (cash and) balances in existence...at any
point of time..."16

The implication which seems obvious, at least to us, is that

 

14. Ibid., p. 608n.
15. Ibid., pp. 607-608.

16. ”Ibid., p. 608.

62

to assume that such a fixed quantity of money exists does not
conform to the facts--it is unreal. Why does Schumpeter be-
lieve this to be an unreal assumption? Fundamentally we
believe the answer lies in the theory he is attempting to
develOp . It is, above all else, a theory of change, of
dynamics, and the explanation of those dynamics. The very
birth of any quantity, or relation of quantities, sets in motion
the forces that will make it impossible for them to endure.
Within the confines of such a theory, fixities are intolerable.

Does this mean that our argument asserting a similarity
between the two theories must collapse? Not at all. The
Keynesian system is not a theory of dynamics. At the most
it is comparative statics. That is to say, Keynes is not
trying to explain the vast complexity of factors that are con-
tinually changing our economic system. His theory of interest
and Schumpater's might be likened to a moving picture in which
thousands of single photographs are moving so rapidly across
the projector that we are enabled to see movement on the screel.
If the camera is suddenly halted at one particular photograph,
however, we have a motionless picture of that particular moment
in the film, This is Keynes's theory of interest, but fig that.
pgrticular moment of timg_and for any other moment at which
we stop the camera, it is also Schumpeter's, by virtue of his
own argument.

We might perhaps expand the argument a bit further.

Keynes is dealing essentially with short run situations.

63

In the short run, the fixed quantity does not seem an unreason-
able assumption. We doubt that Schumpeter would object to
this. Schumpeter further notes that demand curves subject
to strong shifts and distortions are more important in
cyclical phases than curves subject only to shifts along
themselves. There is, so far as the present author can see,
no reason why the Keynesian curves may not qualify as 'good'
curves, since they may be shifted, and quite widely, without
affecting Keynes's arguments. Secondly, and in order to justify
the use of the Wicksteedian demand curve, another assumption
is necessary.

"The owner must then be thought of as paying interest

to himself, either in the form of some element of

return if he uses his money in his business, or in

the form of some satisfaction (equivalent to the loss

of interest involved) if he does not. But apart

from being applicable to the case of perfect com-

petition only, this schema presupposes a string of

assumptions that are entirely inadmissable in the

case of money."16

We agree with Schumpeter that under perfect competition
the argument certainly would hold.17 We do not, however,
agree that this is the only case where the proposition holds.

It is true that the satisfaction will not be of the utility

 

16. Ibid.

17. Under perfect competition, factors will seek alternative
employment if the return is higher than that in the position
they now occupy. It follows therefore, that if interest is
being paid in some sectors of the economy and owners retain
balances, those balances must be earning some sort of return
subjective or otherwise. If they were not, they would flow
to the money market.

64

type of which Schumpeter seems to be thinking. There is,

in spite of this, a definite return which every holder of money
receives. Keynes has provided us with insight into the nature
of this in his liquidity preference theory. People do hold
money because of the three motives described in chapter one,
and interest is the price necessary to induce them to part

with these balances. Since the Keynesian system is most
assuredly not one of perfect completion, it seems, at least

to the writer, that this restriction is not so inapplicable

as Schumpeter believes.

Finally we will consider the two theories in regard to
the 'earth' from which they spring. It cannot be too firmly
emphasized that Schumpeter's whole aim and purpose is to con.
struct a theory of economic development. To begin his theory
it was necessary that he have a starting place, a point of
reference. For Schumpeter this starting point was the state
in static equilibrium described in the preceding chapter.

It does not matter that such a state probably never has nor
never will exist. The important point here is that this is

his insight into the underlying basis of the capitalistic
system. The world is not one of a circular flow, but it would
be were it not for the process of development and the infinite
ramifications of that process. It is possible, and even pro-
bable, that all economists can look at the real world and iden-
tify the same important factors there, i.e. interest, capital,

investment and so on. When economists begin, however, to

65

name the sources from which these factors spring, or to de-
scribe their nature, relative importance, or relation to one
another, differences arise.

Professor Schumpeter has given us a very elaborate pic-
ture of the source of interest and profits in The Theory 23_

Egonomic QeveIOpment. Lord Keynes in The General Theory

 

tells us practically nothing about the source of interest.
This undoubtedly constitutes a difference between the two
theories, but it would seem to be more a difference of omission
than a fundamental point of departure. It is difficult to
see where the Keynesian system would be affected by agreement
with Schumpe ter on this point.

In Business Cycles18 Professor Schumpeter has admittedly

 

carried his discussion of the rate of interest in_§hg_£ggl
E9333 much further than Keynes has seen fit to do in The General
Theogy. Whether or not his (Schumpeter) findings bolster or
weaken the Keynesian position we do not propose to discuss

here. (Our point is simply that in the theoretical models of
both men, there is a plane of theory on which a meeting, as

far as the rate of interest is concerned, is achieved.) We

hope too that we have demonstrated that the Keynesian liquidity
preference is not in Opposition to Schumpeter's theory Of in-

terest, but rather, at least on the supply side, a complement

to it.19

 

18. Ibid., Chapter XII.

19. This Opinion is shared by A. Smithies, "The Quantity
of Money and the Rate of Interest," Review Of Economic
Statistics, Vol. XXV, 1945, although we take —full responsibi-

 

66
THE ZERO RATE OF INTERAST

Before we leave the subject of interest, we shall try
to clear up one more point. As wellave shown, the rate of
interest in the circular flow is always zero.2O At the same
time we know that the Keynesian rate of interest can never
fall to zero, but the liquidity preference curve always levels
Off at some positive rate. Interest can never fall below some
positive rate that will be just high enough to cover the mini-
mum costs and risks involved in making a loan.21 Does this
seeming divergence constitute a real difference between the
theories? We think not. What are the two forces that main-
tain the Keynesian rate of interest at some positive level.
The first, as we have mentioned, is the risk involved in making
a loan; but in the circular flow there is absolutely no un-

certainty, and consequently no risk. The second force is the

 

lity for the manner in which we have worked out our proof.

20. L. Robbins ("On a Certain Ambiguity in the Conception

Of Stationary Equilibrium," Economic JOurnal, Vol. XL, 1950)
insists that a zero rate of Interest Is not compatible with
the circular flow. The argument may be briefly stated. If no
positive rate of interest is present, then there is no incen-
tive for the owner of the factors of production to refrain
from consuming his capital now. The argument has been amply
refuted, we believe, by P. Samuelson ("Dynamics, Statics, and
the Stationary State," The Review 9£_Economic Statistics,

Vol. XXV, 1945). Briefly‘his'argument—is this: substitution
on even terms would mean the units substituted would have a
lower utility in the present than in the future since by being
added to present income they (the units) place themselves at

a lower spot on the diminishing marginal utility curve.

21. See L. R. Klein, The Keynesian Revolution, p. 71.

67

cost involved in making a loan. In our Opinion such costs
are not interest, but handling charges. There is, then, no
real difference implied by the zero rate of savings if we re-
move the restrictive assumption Of uncertainty from Keynes.

CAPITAL

The General_Theory_g£ Employment, Interest and Money
contains one chapter (Chapter 16) in which Keynes discusses
the nature Of capital. In comparison with the Schumpeterian
discussion, it is extremely meager and superficial. We shall
Offer what comparison seems possible under such circumstances,
with the understanding beforehand that Keynes has really given
us very little with which to work.

In so far as we can determine, capital, to Keynes, is
real physical goods, as Opposed to the Schumpeterian notion
that it is the command over those goods, usually money. When
speaking Of the return to capital, however, we speak in what
are substantially money terms.

"It is much preferable to speak of capital

as having a yield over the course of its life in

excess Of its original cost, than as being productive."22

The reason given as to why it is possible for an asset

to offer a prospective yield greater than its initial price

is because the asset is scarce.25 Moreover, it is kept scarce

 

22. The General Theorygf Employment, Interest and Mongy,
p. 213. Italics Keynes's.

25. Ibid.

68

because of the competition of the rate of interest on money.
Clearly, this places capital in the category of real assets.
In Schumpeter, the rate of interest will preform much the
same function. That is to say, innovators will be limited in
the amount of money they will borrow to buy producers' goods
by the expected profit on the marginal increment of those pro-
ducers' goods and the rate of interest.24 Schumpeter would
probably also agree that as these producer goods became less
scarce, real productivity would increase, but the yield (profit
to Schumpeter) would decrease. This does not, however, have
anything to do with the scarcity or abundance of capital in
the Schumpeterian sense. Capital will be limited by the amount
of accumulated money wealth (from past profits) and the amount
by which it is possible to expand credit within the system.
The function of capital, then, is not production, but only the
means by which entrepreneurs may withdraw the factors of pro-
duction, including labor, land, and capital, in the Keynesian
sense, from other firms.

It will be remembered that the two ultimate factors of
production in The Theory 2; Economic Development were labor
and land. Keynes does not disagree with this point of view,

but to him, labor is a great deal more important than land.

 

24. schumpeter would probably say, however, that the expected
profit was much more important than the rate of interest, in
determining the quantity of investment.

69

"I sympathize, therefore, with the pre-classical
doctrine that everything is produced by labour, aided
by what used to be called art and is now called technique,
by natural resources which are free or cost a rent
according to their scarcity or abundance, and by the
results of past labour, embodied in assets, which also
command a price according to their scarcity or abundance."25
It would seem that there is no similarity between what the
two writers consider to be the nature of capital. There is,
however, one possible case in which the two theories seem to
meet, despite the differences in the definition of capital.
The case is outlined by Keynes and may be summarized.26 We
assume first, a rate Of interest consistent with a rate of in-
vestment which corresponds to full employment. The State then
adds to the stock of capital until it approaches a saturation-
point at a rate such that no disproportionate burden is placed
on the present generation. On such assumptions, and with a
pOpulation which does not increase rapidly, Keynes suggests
that the marginal efficiency of capital could be brought to
zero within one generation. At this point, we should be in,
what Keynes calls, a quasi-stationary state. In such a state
change and progress would come about only through changes in
techniques, taste, pOpulation and institutions. The products
of capital would sell at a price just covering the labour, land,

etc., embodied in them, with capital receiving a zero net return.

 

25. Ibid. Italics Keynes's.

26. Ibid., pp. 220-221.

70

Such a State is very close to that envisioned by Schumpeter
in his circular flow. In both the Keynesian and Schumpeterian
stationary states, producers' goods exist and preform the same
function, i. e. the production of consumption goods. In neither
gtg£g_do these producers' goods, whether you call them capital

_————————-

UNEMPLOYMENT IN THE TWO SYSTEMS

The Keynesian system, as we have so often said, is an
attempt to formulate a theory of output determination.
Perhaps more important, as the title of his book, The General
Theogy 9; Employment, Interest and Money, would indicate, is
the determination of various levels of employment. This, however,
is simply a matter of emphasis or interest, for the two (employ-

27

ment and output) are, as we'have shown, assumed to be uniquely

correlated. Professor Lange has attacked the Schumpeterian
system for a failure to provide any such theory of employment.
"The real weakness of his theory appears to be...the
lack of an adequate theory of employment (in the
sense of Mr. Keynes) to serve as a basis for the
theory of the business cycle."28
The most obvious criticism of this statement is that
a theory of employment does not constitute a necessary basis

for a theory of the trade cycle. We may go further and say

that in neither Keynes nor Schumpeter $§.5u°h a theory advanced

 

27. See p. 4n of this manuscript.

28. 0. Lange, Review pf Economic Statistics, November, 1941,
p. 192.

71

22 3 Eggs}; basis for the pycle.

Perhaps it is doing Mr. Lange an injustice to claim that
this is what he meant, for in the paragraph which follows he
seems to mean something quite different:

"The fluctuation of the level of employment (and of the

degree of the utilization of resources) is our primary

empirical datum about the business cycle. As long as

it is not eXplicitly connected with the theory and

g§§%g§gd5 . igsdduetrgle,tProfeisor Sghgmpfiger's theory

mus e regar e , a ’ eas , as ncomp e.

Mr. Lange's criticism would seem, then, to be directed
at the applicability_of the Schumpeterian system, for it is
not at all necessary that a theoretical model, to meet the
tests of logic and consistency, conform to reality. without
becoming involved in any arguments, as to whether the problem
of employment is more important than some others discussed by
Professor Schumpeter, we can agree that the problem does not
in his system enjoy the prominence it does in Keynes's. This
is not to say that the two men view unemployment in any markedly
different manner. It will be necessary that we examine the
matter a little more closely before making any definite deci-
sion as to either their similarity or dissimilarity.

An excellent starting place for our inquiry is found in
the choice of definitions accorded unemployment by Keynes and
Schumpeter. In Keynes we find a very definite distinction

made between frictional unemployment and what is defined as

 

29. Ibid., Italics mine.

72

involuntary unemployment.30 Schumpeter, on the other hand
regards all unemployment as frictional. The seeming differ-

ence is deceptive.31

Schumpeter, as we know, is attempting
to eXplain the process of economic develOpment via innovations.
We have reserved our discussion of the business cycle for the
following chapter, and it is, therefore, necessary to ask the
reader to accept for the moment the Schumpeterian contention
that innovations are the ultimate cause of such cycles. Inno-
vations produce unemployment, because it is impossible for the
economic system to instantaneously adjust itself to the dis-
turbances they engender. That is to say, some Old firms will
be forced out of business by the new innovating firms which
spring up along side them. There is no reason to suppose that
the resources formerly employed by these old firms will be
instantly reemployed by the new. We have thus introduced
cyclical and technical unemployment and both are regarded
by Mr. Schump ter as frictional.

Further

"Imperfections of both competition and equilibrium...

may account for the presence of unemployed resources
independently of the cyclical process of evolution.”2

 

50. See The General Theory, p. 6.

31. The following argument draws heavely upon E. G. Bennion's
"Unemployment in the Theories of Schumpeter and Keynes,"
American Economic_Review, June 1945, Vol. XXXIII, although

all errors of interpretation or of added arguments rest solely
at our door.

52. Business Cycles, p. 161.

75

The differences of definition do not now seem so apparent.
What Schumpeter means to include under the term frictional
is a good deal broader than the meaning attached to the same
word by Keynes. Moreover, since the Keynesian involuntary
unemployment is, at least in part, the result of imperfections
of both competition and equilibrium, the two theories are not
so different from the stafiLoint of definition.53

We have shown that both men are talking about approximately
the same thing when they speak of employment, and we have seen
that unemployment has a definite place in both systems. Pro-
fessor Lange did not, therefore, mean that Schumpeter takes
no account of unemployment. What Lange did mean was that
. Schumpeter has not provided any unique method of determining
the level of output and/Or employment by the functional re-
lationship postulated for the system, i.e. the quantity of
money, the schedules of liquidity preference, the marginal
prOpensity to consume and the marginal efficiency of capital.

That Schumpeter would agree to this, we have no doubt at
all, for he has written

"We have seen that there is_no unique or simple relation
between employment (number of hours worked per week) and

 

33. The Keynesian wage rigidity is a result partly of imperfect
competition, since it is mainly the influence of unions that
prevents money wage reductions. From the standpoint Of equi-
librium, unemployment may accompany many equilibrium points
which are imperfect only in the sense that they are not full
employment equilibrium. Schumpeter defines a concept very
similar to Keynes's involuntary unemployment, which he calls
Vicarious Unemployment (See Business Cycles, p. 515).

74

output, and that the latter is not prOportional

to, or measured by, the former. This is a consequence
of the very nature of economic evolution and becomes
obvious as soon as some of the conditions for
proportionality are stated: production functions

would have 29 be invariant in_time and relative

prices of factors would have to be constant."34

 

We have arrived at the heart of the matter. As Mr.
Bennion has said, if Schumpeter's schema contains an inadequate
theory of employment, Keynes's contains a masterful super-
structure without a foundation on which it may rest.55 By
maintaining production functions invariant, Keynes has ex-
cluded the capitalistic process on which the Schumpeterian
system is founded. The argument may be summarized. Assume
a symmetrical curve devoid of trend and possessing the pro-
perty of unchanging production functions. The curve represents
fluctuating employment, money and real income, all of which
move together. Uhder such assumptions, average real income
would be unchanged from cycle to cycle, and net investment
for one complete cycle would be zero, i.e. investment plus
consumption in the upper half of the curve is exactly Offset
by disinvestment and decreased consumption in the lower half.
It is unlikely that the Keynesian determinants could continue
to assume values wlich would perpetuate this condition yielding
unemployment equilibrium. That is to say, without reference
to dynamic factors, such as changing production functions,

there is no reason why the system should not adjust to some

 

34. Business Cygles, pp. 510-511. Italics supplied.

35. Loc. cit., p. 339.

75

permanent equilibrium, either at full or partial employment,
and.remain there. Further the Keynesian determinants (liquidity
preference, marginal efficiency of capital, and the marginal
prOpensity to consume) rest very largely on a psychological
basis. Such a basis, in and of itself, almost necessarily
posits change. That is to say, the marginal efficiency of
capital and the liquidity preference schedules are both derived
from expectations as to the future course of events. If there
are no ultimate factors (changing production functions) making
the economy dynamic, then there is no basis for these deter-
minants. What point in hoarding if the future is certain?
Could the marginal efficiency of capital move at all? Obviously
what Keynes has done is brought changing production functions

in 'the back door.‘

The Schumpeterian system has at its very core changing
production functions in the form of innovations. Does this
mean, then, that Keynes by introducing changing production
functions, even if by the back door, has allied himself in
reality with the Schumpeterian claim expressed above, that
there is no unique relation between output and employment?

Are we to say now that the Keynesian employment determination
is not valid after all?56 We must answer in the negative.
We are back at the position previously explained, when we

were comparing the theories of interest.

 

36. R. Clemence and F. Doody in The schumpaterian System
have said in this connection that "one innovation in the

 

 

flail‘lll

76

Keynes is thinking primarily Of unemployment at a given
point in time. More specifically, Keynes holds his production
functions rigid, but only for Ehg_yg§y,§h9££_ggn, For such
a time pariod there is no reason why this may not be considered
reasonable and proper. We have Schumpeter's own confirmation
on this point. Speaking of the unique relation between employ-
ment and output, as dependent on invariant production functions
and constant relative fact or prices, he says

"Neither can pOSSibly be fulfilled for any length of

time, such as the period of a Juglar. But both may

be fulfilled approximately in the very short run..."57

It is now possible to state our conclusions. First of all
Professor Schumpeter very definitely does not provide a method
of determining the volume of employment at any particular
point in time. In this sense his theory may quite properly,
and without harm to that theory as such, be considered inade-
quate. On the other hand, Keynes just as definitely does
provide an adequate theory Of employment and output determina-
tion for the very short run. At the same time, it must be

admitted that Keynes does not provide an adequate explanation

of employment through time, while Schumpeter does.

 

Keynesian model would spell goodbye to the whole structure."
(p. 59) It is their contention that in a world in which
innovation exists, changing production functions will contin-
uously destroy the unique relation of employment and output.
In the writer's mind, however, all that need be valid for the
Keynesian system is that the relation between output did exist

at any one moment of time.

57. Business Cycles, p. 510.

77

With one assumption it is possible to make the two theories
complementary. That assumption is that economic development
has not ceased. If we reject this in favor of permanent stag-
nation, then we have literally defined Schumpeter's system
out of existence. Accepting the assumption, however, and it
seems reasonable at this time, we can then proceed to say that
Schumpeter's theory of development will explain the cause
and direction of employment through time, and that Keynes's
functional relations may be used to explain the volume<3f
employment at any given point of that time.

THE THEORY OF PRICES

Because we have not as yet devoted any Space to price
theory to any significant degree in either theory, we Small
begin by very briefly outlining the two theories. To save
time we shall outline Schumpeter's theory first and then attempt
to work out our comparison alongside our develOpment of Mr.
Keynes's theory.

The Schumpeterian monetary equation may be written as
follows: E - MfU . plmli'P2m2+ ... ann-58 The income of the
period being considered is represented by E, M is the quantity

of money, U its average velocity of circulation and p1, p2

 

38. The equation is taken from Schumpeter's article "Das
Sozialprodukt and die Rechenpfennige,", but because the ori-
ginal article was not available, we have relied on partial
translations by W. F. Stolper, "Monetary, Equilibrium and
Business-Cycle Theory," Review ngEbonomic Statistics, 1943,

.V01. XXV.

78

and pm the prices of quantities m1, m2, and mu. The quantity
Of money is defined as anything that will pass as money.39
_There are some reservations, however, on what this may be taken
to mean. Money that may be used to create money, temporarily
idle balances and minimum reserves of banks and individuals
are excluded.
"The theory of the sum of total income does not deal
with the total circulating medium. For this theory,
and for the monetary nexus, only that part of the
circulating medium is relevant which in every economic
period is spent by the producers on the factor markets,
is received by the furnishers of the factors of
production, and is then brought into the market for
consumers' goods....On1y this sum enters into the sum
Of money incomes, and only it confronts the stream
of consumers' goods and affects the value of money."40
The velocity of circulation (U) is defined somewhat differently
than the usual quantity theory interpretation. Briefly stated
it is the number of times money is received and spent g§_income
g§_consumption goods within any given period. Despite the
differences in definition as regards the components of the
equation, it is a simple truism without any causal meaning.
A change on the left side of the equation supposes a change
on the right. The quantity of money (M) is considered to be
the active factor, while velocity (U) is assumed to be fairly

constant.41 It follows, therefore, that U remaining constant,

an increase in M will mean an increase in production or prices

 

59. Ibid., p. 89.

40. Ibid., p. 89. The quotation is also a Stolper translation
from the article cited.

41. Ibid., p. 90.

79

(pm). In general, says Stolper, an increase in M effects
production via the fact that all prices do not change in the
same degree and at the same time. This fits in very nicely
with Schumpeter's theory of develOpment. In the circular
flow there is no net investment, and so the emphasis is, as
shown above, strictly on consumption. Innovations are also
neatly taken‘care of, because prices do not all change in the
same degree at the same time. Factor prices are assumed to
lag behind product prices. This creates the price differential,
which we have described in chapter two as entrepreneurial
profit. When the quantity of money ceases to rise, then a
new equilibrium will be established with these profits
eliminated in the manner described earlier.

The Keynesian theory of prices has been called the contra-
quantity theory of causation. This appelation springs from
the fact that, as opposed to the Schumpeterian theory just
examined, changes in the quantity of money (M) originate through
changes in prices and not vice versa. The emphasis has been
shifted from the left to the right hand side of the equation.

In the special case (to Keynes) of full employment, such
as the circular flow, there would seem to be no substantial
disagreement regarding price theory. In such a situation
prices are determined for the firm by factor costs and by the

principle of increasing costs (diminishing marginal productivity)42

 

42. See The General Theory, p. 294.

80

connected with expanded production. This jibes very well with
Schumpeter's circular flow where, it will be remembered,
marginal cost equals marginal revenue.

In the present writer's Opinion one of the real differences
between the two theories arises out of differences over a
concept already discussed, the theory of interest, because
Keynes regards interest as being a link between the present
and the future. The difference is centered in Keynes's pre-
occupation with a less than full employment state Of equili-
brium. Under such conditions increasing the quantity Of money
will not effect prices, because there exist idle resources.
The increased quantity of money will, however, have important
repercussions on the rate of interest. If the liquidity pre-
ference schedule remains constant, then the rate of interest
must Of necessity fall. If it falls below the marginal effi-
ciency of capital, then investment will be stimulated. Idle
hoards and peOples desire for balances, which Schumpeter ex-
cluded from his definition of M, play an important part in
the Keynesian theory.

Schumpeter has recognized the same phenomena as we indi—
cated when discussing the rate of interest. In discussing
the effect of an increase in the quantity of gold, flildh we
may assume to be the same as an increase in the quantity of

money, he has this to say:

"All these factors together, namely the decline Of the
rate of interest, the fall in the real content of

81

debts and fixed interest burdens...create a tendency

toward expansion of all firms...45

TO expand the Keynesian theory a bit more we should note
that, as might be expected, he is interested in13he effect of
changes in the quantity of money on output. If the wagex'ate,
which is the major factor in price, is assumed to be rigid and
there are idle resources, then velocity being a constant, the
effect of an increase in money must mean aneaqual or propor-
tionate increase in output. This must be true since output
is the only variable whichxremains free tO move under these
conditions. Under these assumptions the Schumpeterian equation
will give the same result.. That is, if the price level is
assumed to be rigid, then an increase in M will mean either
an increase in output or velocity. If we hold velocity (V)
to be constant, the results are identical with those of Keynes.

In this simplified form there do‘“ not appear to be any
real differences between the results possible with both theories,
although the Keynesian causal path is different from that taken
by Schumpeter. Keynes goes on, however, to introduce some
important qualifications. The above increase in output pro-
portional to the increase in money will hold, first of all,
only if effective demand also changes in exact proportion

to the quantity of money.44 The general case will be that

 

43. Stolper, Ibid., p. 90. His translation of Schumpeter.

44. See The General Theor , p. 296.

82

the increase in effective demand will spend itself partly
on increase employment/output and partly on price rises.
The price level will not, strictly speaking, be rigid then,
but will rise gradually with employment.

The main factors behind this gradually rising price level
may be briefly reviewed. First of all, as unemployment de-
clines, the bargaining position of workers improves, and wages
will rise. Secondly, increased demand over the short run will
result in diminishing returns because of the inability of the
quantity of capital, etc., to change quickly. Thirdly, we en-
counter bottlenecks in production. That is to say, some in-
dustries will exhibit inelastic output with reapect to increased
demand.45

Now Mr. Schumpater does not have any such complete theory
of effective demand as Keynes. Whether this should be counted
as an error of ommission or of analysis, we are not prepared
to say. The factors just named, however, which are behind
effective demand's failure to change proportionately with out-
put, are certainly not in disagreement with anything Schum-
peter might have to say. On the whole they are, fundamentally,
conditions brOught about by frictions, the imperfections of
competition and the inability of the system to adapt instan—
taneously to change. As such, the writer cannot see any reason
why Schumpeter should argue that the effects Keynes attributes

to them would be other than those described.

 

45. See D. Dillard, The Economics pf John ngna d Keynes,
pp 0 228-252 0

CHAPTER IV

THE OVERALL VIEW

We come now to the final chapter of this work in which
as we indicated earlier we intend to compare the complete
systems of both economists. In the preceding chapter we have
briefly compared what we considered to be the essential com—
ponents of both systems. We have reserved the discussion Of
the business cycle until now, although it could be objected
that the cycle is really only a component of either system.
We have no wish to argue with such an objection. Our decision
was admittedly arbitrary, although in the case of Professor
Schumpeter we do believe that his whole system is aimed at
explaining the capitalistic process which he believes to be

necessarily_cyclical. Because we have not previously discussed

 

either man's theory of the cycle we will begin with a brief

summary of both.

THE KEYNESIAN THEORY OF THE CYCLE

The explanation of the trade cycle Offered by Lord Keynes

centers in the concept of the marginal efficiency of capital.1

 

1. What little Keynes has to say about the trade cycle is
contained in Chapter 22 of The General Theor . The explanation

is meant to be suggestive and should be cons dered as incomplete
(See p. 313).

84

We shall begin with the economy on the point of being launched
into period of boom conditions. (Since the marginal efficiency
of capital is determined by two elements, the supply price of
new capital and the state of expectations we should examine
both of these elements{) In regard to the supply price of capital
assets we can assume that it will be relatively low since there
is as yet no stiff competition for capital. The capital in-
dustries themselves are not as yet Operating at capacity and
so may be assumed to be Operating as yet along the decreasing
costs area of their cost curves. Expectations, the other ele-
ment in the marginal efficiency of capital, are extremely
optimistic. Businessmen believe that economic conditions are
good and will continue to improve indefinitely. In short the
marginal efficiency of capital is high. Interest rates, the
other determinant of investment, are probably low. With peOples'
expectations Optimistic, the amount of money they will want
to hold (liquidity preference) decreases. This is so because
peOple believe that the prices of investments are going to
rise. This is the same thing as saying the rate of interest
on these investments will fall. It is therefore more profit-
able to switch into assets and profit from the rise in prices
rather than stay in money at a falling rate of return.
Conditions are thus very propitious for new investment.
Each new injection Of investment results in a great increase
in income because of the multiplier principle. he are in a

cumulative period of expansion.withuemployment and income

85

increasing rapidly. What causes this period of expansion to
end? The main factor which brings about the down turn, or
what is known in cyclical theory as the crisis, is the sudden
collapse of the marginal efficiency of capital.

What brings about this collapse in the marginal efficiency
of capital? In the realm of psychological factors the bright
wave Of Optimism gives way tossome skepticism as to the ability
of capital to maintain its present high return indefinitely.
Such skepticism will cause some businessmen to hold back on
investment in anticipation of price declines. In the realm
of real factors the investor finds himself caught in the old
profit squeeze. That is to say, his costs have continued to
rise and are still rising. The market, however, is being
flooded with the goods that were the ultimate end Of the in-
vestment started at the inception of the boom. Therefore, the
price of his products are being forced down. The entrepreneur
who began his investment with an expectation of a 7 or 8 per
cent profit finds his actual return is perhaps nearer 3 per
cent. When this disillusionment strikes it hits with sudden
and catastrophic force.2 The Optimism which characterized the
boom turns overnight into excessive pervading pessimism.

With the collapse of the marginal efficiency of capital

the rate of interest also exhibits a marked rise.3 The reason

 

2. See The General Theory, p. 316.

3. Keynes makes quite a point of insisting that the increase
in liquidity preference and the consequent rise in the rate

86

is the reverse given for its decline in the early stages Of
the boom. Since peOple expect prices to fall and,therefore,
the rate of interest on investments to rise, they fly to money.
The downswing also exhibits a cumulative characteristic. Each
successive fall in investment brings about, via the multiplier,
a greater fall in income.4 The limits of such a contraction
are reached when income equals consumption.

We shall conclude our short discussion of Keynes's ideas
on the trade cycle by some observations on the length or period
of the average cycle. There are, according to Keynes two main
factors that will determine the length of the cycle. The first
is the length of life of durable assets in relation to the
normal rate of growth.5 By this is meant the average time
necessary for depreciation and Obsolescence to raise the
marginal efficiency of capital above the rate of interest

via scarcity. This interval, "may be a somewhat stable function

 

zof interest occurs after the crisis. High interest rates
, might therefore retard the boom, but he questions the

efficacy of low interest rates to affect the depression.
‘\See The General Theory, p. 316.

4. The nature of the multiplier will tend to help level off

the boom and cause income to fall §E_an increasing rate in \
the downswing. This is so because as-Income increases, the 1
mar inal propensity to consume declines dampening the mul- /
tiplier effect. While in the downswing with income decreasing
the marginal prOpensity to consume rises, which increases the
effect of the multiplier.

5. Ibid., p. 517.

87

of the average durability of capital in a given epoch."6

This standard period will vary as the characteristics of the
epoch vary. A slowing of the rate of pOpulation increase

will cause the period to lengthen because the demand for capital
to meet increased population is decreasing.

The second factor limiting the length of cycles is the
carrying costs Of surplus stocks. When the downturn starts
prices fall so rapidly that if Some producers were to keep
their inventories moving they would have to do so at a loss.
Rather than endure such losses, businessmen will hold back
in the hOpe that prices will rise eventually. Actually, of
course, this is self defeating, since it means less employment
and less income, etc., on and on. The length of time such
inventories will be held naturally depends on the costs involved
in storing goods, tying up money in assets, etc.

Taking both facts into consideration. Mr. Keynes concludes
that the length of time which will be established and which will
display a fair degree of regularity will be between three and
five years.7 This conforms well enough with orthodox cycle
theory as far as short run cycles are concerned, the cycle

identified being that generally known as Kitchin's.8

 

6. Ibid., p. 318.

7. Ibid., p. 317.

8. See Estey - Business C cles, p. 15.

88
MR. SCHUMPETER'S THEORY OF THE CYCLE

Because of limitations of Space, our summary Of what
Schumpeter has to say about the trade cycle will be nearly as
brief as our summary of Keynes. This is deceptive. The
Schumpeterian theory is much more complete than the one chapter
Lord Keynes devotes to the subject. We shall go into this
in more detail when we contrast the two theories, but it would
be well to keep the above in mind.

We may conduct our examination of Schumpeter's theory
of the cycle on two different levels. We are interested mostly
in the second approximation but will outline first the theory
Of cycles in the pure model, the circular flow concept de-
scribed earlier. As we know, in the beginning such a system
is in a state of perfect equilibrium. Along comes our in-
novating entrepreneur who succeeds in establishing his new
firm in the midst of a hostile world. He is followed by a
host of imitators financed by a great expansion Of credit.

The great expansion of credit and the investment activity
creates prOSperity. At some point the rush of imitators will
exhaust the possibilities of further profitable Opportunities.
As a result, borrowing will diminish. The expansion will
begin to slow down. As the firms who first begun to innovate
start paying back their loans there will be a further impetus
to deflation of the monetary expansion. At about the same time

the market begins to be flooded with the goods produced by the

89

new firms. Depression results, and during this period the ad-
justments necessary to bring the system back to a new equili-
brium are carried out. Those firms whichtare no longer able
to compete will disappear from the economic scene. For those
who are left there is a need for a complete reorganization.

"A great many values are annihilated; the fundamental

conditions and presuppositions of the plans of the

leading men in the economic system are changed."9

What this will mean practically is that some of the new
firms will become leaders; others will contract, modernize,
and otherwise adjust to the new equilibrium. We have in the
pure model only a two-phase cycle of prosperity and depression.
As soon as the necessary adjustments have been completed, the
system is at a new equilibrium point. At this new equilibrium,
real income is greater than that at the previous point, be-
cause the innovation has increased output, relative to employ-
ment.10 The price level is lower, too, because competition
has forced prices down until they equal marginal costs under
a new production function (the innovation) which is more
efficient. The length of the cycle phases will depend on the
type of innovation that is introduced and the resultant nec-
essary period of adjustment. The building of a vast system

of railroads, for example, would take much longer than a new

way of making shoes.

 

9. The Theorygf Economic DevelOpment, p. 127.

 

10. These elements are taken1?rom R. Clemence and F. Doody,

The Schumpeterian System, p. 12. The following description
of‘that second approx ation leans heavily on hapter3 30f

the same work.

 

90

The Second Approximation is an attempt to bring the theory
closer to reality. It is a direct result of adding to the
Pure Model six new elements. They are (1) the secondary wave,
(2) successive fluctuations, (3) growth, (4) the Spreading
of credit creation, (5) induced investment, and (6) imperfec-
tions of competition and of equilibrium.11

The primary wave is that just described in air discussion
of the pure model, having as its basis the introduction of
innovations. The secondary wave is at least quantitatively
more important than its primary parent. Mostly it is a result
of reactions to the primary wave. The rise in investmelt
brought about by the new firms, brings with it a use in aggre-
gate income. Part of this increase in income willlae channeled
into consumption Spending. This will cause an increased demand
for the products of both old and new firms, which in turn will
lead old firms to attempt to expand to meet the new demand.
Similarly, peOple in all types of business make their plans
on the asslmption that present conditions will be extended into
the future. Specukltion and excess of all types follow neces-
sarily until the secondary wave has obscured the underlying
factors that were responsible for its existence. Moreover,
the characteristics Of the secondary wave we have just de-

scribed lead readily into a boom.

 

11. Ibid., p. 247.

91

The downturn will come when the primary wave upon which
the whole boom actually rests turns downward according to prin-
ciples outlined in air discussion of the puremodel. There is
a fundamental difference, however, between this downturn and
that experienced under pure model conditions. In the pure
model the recession was primarily one of adjustment to the new
conditions created by the innovation. The secondary wave, how-
ever, has created a great many positions which have no real
foundation in the underlying data. They are completely de-
pendent on the continuance of the secondary wave boom. Once
the downturn starts, these positions become untenable, resulting
in an abnormal liquidation. This abnormal liquidation will
force the economy downward, through recession, into depression.
Firms which should, under the recession conditions of the pure
model, easily survive are forced into economic limbo; sound
positions, too, are liquidated. The depression ends partly be-
cause readjustments are gradually made and partly because of
self-generating factors, i.e. capital equipment finally wears
out, the interest rate falls, etc., and the system enters the
recovery phase of the cycle. We thus have a four-phase theory
of the cycle familiar to cycle theorists. One thing must be i
kept in mind. Every cycle is to Schumpeter a historic indi-
vidual. There is no necessary regularity or periodicity to
any group of cycles. It is not even necessary that all will

follow the pattern we have just outlined. To understand any

one cycle, we must know the conditions at the time of its

92

inception, the nature and type of reactions, and finally the
kind of adjustments that are made to any new conditions it
produces.

It remains toeaxplain the other five elements listed above.
By successive fluctuations we mean that rather then starting
from a position of perfect equilibrium, we recognize now that
all new cycles start in

"...an atmosphere of imperfect routine containing

innovations incompletely worked out, undigested

elements of previous cycles, faulty adjustments

resulting from errors, and so on..." 2

Growth is the result of pOpulation changes and in aggre-
gate savings correcred for changes in the purchasing power
of money.15~ POpulation may influence the course of cycles
by its effect on demand. Savings will exert their influence
either by financing innovations or as idle balances which
reduce demand.

It will be remembered that in the circular flow the
creation of credit was necessary to give the entrepreneur
control over the means of production. Once begun, however,
credit creation spreads throughout the system, becoming an
instrument for financing all business. Thus, the expansion of

positions which later become untenable, because theytare un-

related to the primary wave, is made possible.

 

12. Ibid., p. 14.
15. Ibid., p. 15.

95

Induced investments are those investments which are
brought into being as a result of an innovation. They are
not, however, necessarily connected with the innovation. The
increased aggregate monetary demand it produces makes profitable
investment possible in many corners of the system. A parti-
cular kind of innovation, such as railroads or automobiles, may
make a huge steel industry a necessity, and so on.

The assumptions of perfect competition and equilibrium,
so essential to the circular flow, just do not exist in the real
world, and so must be abandoned. By introducing imperfections
of this kind, we make the process of adjustment more difficult.

MULTICYCLES

This concludes the purely theoretical part of the Schum-
peterian cycle, but there is one more point to be made. As
we have said, cycles of varying lengths and periodicity are
possible under our analysis. There are three fundamental
factors that will determine the length and nature of each

cycle.14

First, and most Obvious, different innovations would
require different lengths of time for their introduction.
Secondly, some innovations will give rise to a whole sequence
of cycles associated with it and of the same type. As an

example we could use the develOpment of the automobile and

 

14. Ibid.,}p. 18-21. The following draws heavily from this
section Of the book.

94

the whole host of industries, such as the rubber business

and highway construction, that grew up as a direct result of
it. Finally, a number of innovations may be interdependent,
forming part of a larger process that represents a real phe-
nomena in and of itself. The Industrial Revolution is offered
as an example. Generally this type of wave is associated

with all pervading upheavals in the whole social frame work.

The insufficiency of data and the shortness Of the period
covered by it have made historical identification of such
cycles extremely difficult. Three cycles which have gained
fairly wide acceptance have been integrated with the Schum-
peterian theoretical system, although that system is not
dependent on either the acceptance or rejection of any of these
cycles. The cycles used are the Kondratieff, the Juglar and
the Kitchin, having average periodicities of about fifty-five,
eight, and three and one-fourths years reapectively.

The interrelationship of these cycles are extremely illumi-
nating from the standpoint of understanding the workings<3f
the Schumpeterian system. Underlying the Juglar is the Kon-
dratieff. The phase of the Kondratieff will condition the
fluctuations of the Juglars. That is to say, in the upswing
of the Kondratieff the prosperity phases of the Juglars will
be more intense , and in the Kondratieff downswing, Juglar
depressions will be accentuated. Equilibrium in the Juglars

is, at best, a partial adjustment to the recent innovations.

95

In terms of our secondary wave, such interrelationships
may,quite logically,completely Obscure the primary wave effects.
If a Juglar is in the strong upswing of a long wave, then
a downturn of its own primary wave will not be enough to cause
the secondary wave to follow it. Finally, this seperation
into three types of cycles is admittedly a practical device.
Other cycles probably do exist, and their effects will make
identification of all individual cycles and their causes
impossible.

The Kitchins are related to the Juglars in the same way
as the Juglars are related to the Kondratieffs. The possibi-
lity is left Open that Kitchens may not be real innovation
cycles but only adaptive fluctuations.

We are now ready to begin our comparison. The first and
most important point we wish to make is that ggpcygle theories,
there is simply no comparison at all. Keynes's theory is not
logically self—contained. That is to say, his determinants
cannot indefinitely take values that will yield a cycle.15
If Keynes is to have a cycle theory at all, it is necessary
that he introduce, albeit implicitly, some underlying dynamic
theory as a foundation for his own superstructure. The Schum-

peterian system is logically self-contained in the sense

we have said Keynes's was not. There is no vital reason why

 

15. We have mentioned this before in discussing production
functions. See E. G. Bennion, "Unemployment in the Theories
of Schumpeter and Keynes," American Economic Review, June
1943 3 pp 0 556-537 0

96

the Schumpeterian system Should be used as background for the
Keynesian system (there are other dynamic theories), but there
is also no reason why it should not be so used. Infact there
is some evidence that such a procedure would not meet with
the disapproval of Lord Keynes. In his Treatise 92_Mgggy3
he stated emphatically that

"Schumpeter's theory of innovations was unreservedly

accepted...as the moving force of the capitalist
fluctuations."16

It is true that no such prominent position is given Schumpeter's
innovations in Th3 General Theory; in fact, they are not even
mentioned. This does not mean that Keynes had repudiated his
earlier acceptance of such a theory. Keynes was not, primarily,

concerned in The_General Theory with considering the capitalist

 

system's fluctuations. His main preoccupation was with the
depression phase of the trade cycle and an explanation of

the various levels of unemployment that existed in that atmos-
phere. It was necessary, if his functional relationships

were to produce the determinant levels he was seeking, that

he introduce certain rigidities among them, production func-
tions which excluded innovations. In the writer's Opinion,
however, Keynes understood that such.conditions could only
hold in the short run. Dut it is equally true that such a

short run period was all that really concerned.him for the

 

16. L. Klein, The Keynesian Revolution, p. 16. A footnote
referring to Schumpeter is omitted.

97

problem he was attacking. In Short we can find no reason to

 

believe he would have discarded his early approval of Schum-
peter's doctrines had he been developing anything like a 223:
plgtg_theory of the capitalistic process.

INNOVATIONS AND THE MARGINAL EFFICIENCY OF CAPITAL

The fundamental cause of an increase in net investment
in the Schumpeterian schemata is the introduction of innova-
tions. In the Keynesian system, a rise in the marginal effi-
ciency of capital over the rate of interest receives credit for
the same function. Are the two incompatible? we think not.
First of all, the marginal efficiency of capital 13 not basic
i§_ang.2£_itself. By this we mean that the causes behind
movements in the marginal efficiency of capital are not ex-
plained py_that concept. Let us examine this. The two deter-
minants of the marginal efficiency of capital are the supply
price of new assets and the expectations regarding the rate
of return over costs. Of these, expectations is probably the
more important. What is it that causes expectations to rise?
About the only cause one can gatherITrom Keynes is that future
prices, relative to costs, are expected to be higher than they
now are.17 But this does nottell us ghy they will be higher.

It is probably obvious totthe reader by now that the

point we are leading up to is that if we introduce innovations,

 

17. See Thg_General Theory, Chapter 11.

98

then we can supply the why behind rising profit expectations.
Innovations, as we know from chapter one, always give the
promise of a return over costs whichAne have called entrepre-
neurial profit. This is not to say that only those invest-
ments which could be considered innovations have relevance

to the marginal efficiency of capital. KBynes's concept
applies to any type of new investment. This presents no
difficulty for we have explained above the manner in which
profit expectations spread throughout the system via the
secondary wave.

One more point needs clarifying. Schumpeter asserts that
innovations always cluster around a point of equilibrium.18
This is obviouslngquilibrium.in the general Keynesian sense,
for Keynes postulates a large number of possible equilibrium
positions up to and including full employment. In he cir-
cular flow a perfect equilibrium starting point would be possible
In the real world with which Keynes is primarily concerned,
however, Schumpeter supposes such a point to be most nearly
reached at the end of the recovery phase of a Kondratieff

cycle.19 What are the conditions that characterize such a

point? First and most important it is a period of generally

 

18. See The Theory 9; Economic DevelOpment, pp. 226-255.

 

19. See p. 93 above.

99

rising prices. Prosperity outruns depressions, and Optimism
regarding the future is prevalent. Now it is true that Keynes
identifies no such specific point, but aren't the conditions
we have described very similar to those he poses as prere-
quisites for a rise in the marginal efficiency of capital?

We believe they are.

In conclusion, let us say that while the theory of inno-
vations may not be the only basis for the marginal efficiency
of capital,&ti seems adequate. While the Keynesian theory
does not go beneath. the surface to causes, the marginal effi-
ciency of capital can be used very neatly to explain the
mechanism of innovations which are themselves causal.

THE LENGTH OF CYCLES

Mr. Keynes has identified his cycle with the so-called
Kitchin cycle of about 40 months duration. Under the shcrt
run conditions, to which he confined.his analysis, it is not
difficult to see Why this was the one cycle which was consis-
tent with his aims. Schumpeter, also, has seen fit to identify
his theory with Kitchin's, but not to the exclusion of Kon-
dratieff's and Juglar's, which he considers to be more impor-
tant.20 Moreover, if Professor Schumpeter's analysis is
correct, then the whorter Kitchin cycle will contain and be

conditioned by elements of both other cycles. If our reasoning

 

20. See Clemence and Doodey, The Schumpeterian §ystem, p. 21.

100

on this point is correct, then it would seem to us that a good
deal of the neat preciseness of the Keynesian explanation is
open to at least some doubt.

POLICY

Probably nocxher result of the Keynesian analysis is
better known than that it lends itself admirably to a positive
type of policy. Such a result was by no means accidental.
Keynes was a brilliant economist with a rare insight into the
workings of the capitalist system, The problem he saw there
was that of vast unemployment in the midst of tremendous capi-
tal accumulation. Such a situation was to Keynes absolutely
intolerable. His insight gave him, perhaps almost intuitively,
the answer to the problem or at least an answer. To have
stated that answer in the usual language of the day would not
have been enough. It is perhaps unfortunate, but true, that
to gain a real hearing it is necessary to startle, to insult,
and to confound. There can be no doubt that Keynes has gained
his hearing. More important, The General Theory, at kaast,
segmgg_to reduce economics once again to the level where all
could understand. If policy suggestions are to gather in
wide backing, this is absolutely necessary.

Mr. Keynes has gained his point, but at the eXpense of
nearly obscuring much that was good in the long history of
economics that had preceded him. It is very probable that

Keynes did not mean that his analysis should be carried a)

lOl

far~—that he was not himself a Keynesian. we have Schumpeter's
Opinion on the matter.

"The logic of the classical system is not really
impugned (p. 278)."21

The theoretical was never as important to Keynes as the
real.

"With Keynes, practical advice was the goal and
beacon light of analysis..."22

Schumpeter, on the other hand, was not, at least in his
two main works, Business Cycles and The Theory 2: Economic
DevelOpment, concerned with policy implications at all. He
was not interested in any one economic problem, but rather
he tried to explain the nature and working of the whole
capitalistic system. As weliave indicated earlier, the
Keynesian determinants cant>e used to eXplain a EEEEE.$E.EEEE
within the Schumpeterian schemata. Whether or not the Keynesian
policy implications would also be applicable, we should not
care to say. This much we will venture. There seems to be
throughout the 'house Séhmpeter built' a feeling that over
everything hangs the mantle of natural law. Depressions with
their concomitant unemployment may be bad, but the depression
has a definite place in the system. Without it the deadwood

could not be diSposed of, nor the vital readjustments made.

 

21. J. A. Schumpeter, "John Maynard Keynes," The Americgn
Economic Review, September 1946, p. 5lon. The italics are
Schumpeter's, and page numbers refer to The General Theory.

 

22. Ibid., p. 504.

102

We shall conclude by noting that it was probably unfor-

tunate that Schumge ter'

troubled thirties when
Keynesian Revolution.
shamefully by-passed.
will not be contested,

A. Schumpeter were men

3 main work should appear during the

all else was Hanketed by the so-called
His work stands in real danger of being
One last comparison which we feel certain
both John Maynard Keynes and Joseph

of their age and great economists.

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