The 2012 presidential race will be, in part, a showdown between two different models of economic growth. President Barack Obama and his Democratic administration will defend the once-discredited and now-resurgent theory that government must act as the economy’s “tutor” and use public funds to stimulate it. The Republican nominee, presumably Mitt Romney, will advance the free-market argument that the main source of new growth is the innovative energy of American entrepreneurs and that government needs to get out of the way.

Illustration by Robert Pizzo
Illustration by Robert Pizzo

An essential part of the free-market argument is “creative destruction,” a theory proposed by the great Austrian economist and Harvard University professor Joseph Schumpeter. If you don’t understand Schumpeter’s insight—expressed most powerfully in his classic 1942 book Capitalism, Socialism and Democracy—you’ll have a hard time understanding why free markets work so well to generate prosperity. Yet creative destruction is a complicated concept, poorly understood by the general public and not always easy to defend. As November nears, the Republican nominee will have to figure out a way to show voters how essential it is to American prosperity.

Schumpeter believed that progress in a capitalist economy requires that the old give way constantly to the new: production technologies in a free economy improve constantly, and new products and services are always on offer. But this creative transformation also has a destructive side, since it makes earlier products and services—and the workers who provided them—obsolete. Today’s consumers have little reason to buy an oil lamp instead of a lightbulb, or a Sony Walkman instead of an iPod—which can be bad news for the people who manufacture the oil lamp and the Walkman.

Looking back at the history of Western capitalism, we can see how the discovery of new energy sources, new communications systems, and new financial instruments regularly demolished old ways of doing things. When this happened, the result was typically short-term pain, as certain workers found themselves displaced, and sometimes even what appeared to be economic crises; but there was also substantial long-term gain, as the economy became more efficient and productive. Economists W. Michael Cox and Richard Alm point to transportation as a striking example of the process. “With the arrival of steam power in the nineteenth century, railroads swept across the United States, enlarging markets, reducing shipping costs, building new industries, and providing millions of new productive jobs,” they write. Automobiles and airplanes had similar effects. Yet “each new mode of transportation took a toll on existing jobs and industries. In 1900, the peak year for the occupation, the country employed 109,000 carriage and harness makers. In 1910, 238,000 Americans worked as blacksmiths. Today, those jobs are largely obsolete.”

Creative destruction can take place not just across sectors of the economy but within particular firms, too. Since the invention of the automobile, many automakers have disappeared, unable to improve their products; those that survived have had to transform themselves radically to stay competitive. Sometimes firms even change their business to stay alive. Think of IBM, which started in 1930 by building calculating machines, shifted to computers in the 1950s, and today is a service company.

Trying to prevent creative destruction brings economic torpor or worse. At the extreme were the twentieth century’s totalitarian Communist regimes. I vividly recall the Soviet economy under Brezhnev and the Chinese economy under Mao Zedong. In these state-controlled societies, competition was illegal and existing factories were never shuttered; every industrial complex contained layers of antiquated technologies to which more recent ones had been added. To close down a factory, after all, would imply that the central planners had made mistakes—an impossibility, since socialism was supposedly scientific.

Innovation is very rare under such state-stifled conditions. In East Germany, factories produced the same car—the only one available—for three decades: the infamous Trabant. Without competitors providing consumers with other choices, there was no incentive to do anything else. Visiting Communist countries during the seventies and eighties, as I frequently did, was to enter a museum of industries past. In the poorly stocked shops, one would come across outmoded devices, like mechanical watches, long gone from advanced capitalist economies. In- deed, most of the innovative products that did surface in the Communist world—usually for the benefit of the military—were stolen or smuggled in from the West.

The same weakness affects, though less dramatically, the watered-down form of state economic planning often practiced in European democracies and renascent in America under the Obama administration, with its Keynesian stimulus spending, massive bailouts of the auto industry, partial takeover of General Motors, and subsidies of alternative energy. The track record of such economic intervention in democratic societies has been stagnation, though it has occasionally proved useful in emerging economies, like Japan’s in the 1950s, when capital is scarce and entrepreneurs are thin on the ground. Even in Japan’s case, though, many of the government-backed industries failed, while sectors of the economy that weren’t nurtured by the state’s “industrial policy”—cars, components, ceramics—flourished.

Central planners can never match the private innovators of a competitive economy. (Friedrich Hayek called this bureaucratic arrogance the “fatal conceit.”) A bureaucrat would need omnipotence to anticipate, let alone invent, the paradigm shifts that capitalist economies, churning with creative destruction, have regularly birthed. Economies open to creative destruction have innovated more, created more employment, and enjoyed higher growth rates than their statist rivals.

No place has been more open to creative destruction than the United States, where whole cities, left behind by technological advance, have crumbled into ruin, with abandoned factories standing forlornly alongside rusted railroad tracks and many workers long since departed to clear new lands, like the pioneers of yesteryear. The willingness of Americans to endure creative destruction has allowed their economy to outperform European economies for decades. But creative destruction always runs the risk of ruining the lives of individuals along the way, which poses a significant political problem for defenders of free markets. Consider an example from overseas. Rail now allows travelers to zoom easily and quickly from London to Paris and back. Who, then, needs the slow-moving ferry that links Dover and Calais? But just try explaining Schumpeter’s virtues to a unionized sailor!

Yes, free-market advocates can point out that when a state steps in to help a dying sector of the economy, it is actually harming economic growth by sinking financial capital—a limited resource—into inefficient activities and diverting funds from more innovative enterprises. A job saved in an obsolete economic sector, they will say correctly, is a job—often many jobs—forgone elsewhere in the economy. But that’s a very hard argument for a politician to make. As the great free-market economist Milton Friedman frequently observed, a business closing gets on the television news, while the new businesses that get created from the reallocated capital go unnoticed because they are so widely dispersed.

Mitt Romney has run smack into this problem during his campaign for the Republican nomination. Bain Capital, the firm he led, was a pure engine of creative destruction: a private investment fund that bought troubled businesses, restructured them (often by firing people), and sold them for a profit. Even some of Romney’s Republican opponents, who know better, couldn’t resist attacking him for his entrepreneurial work; Newt Gingrich went so far as to run ads featuring workers who had lost their jobs because of Bain’s restructuring. Romney contended that Bain had helped create 100,000 new jobs, which may be true, but—underscoring Friedman’s point—no one knows exactly where they are.

It may therefore be necessary for defenders of creative destruction to balance Schumpeter with some form of social support. It is misguided to protect superseded firms and industries, they would maintain, but helping people displaced by economic progress is a moral imperative. They would argue for the implementation of a “compassionate capitalism,” perhaps including unemployment benefits, retraining, and various welfare services. (These should be designed not to become disincentives to work, as they frequently have been in the past.) A compassionate capitalism wouldn’t merely be humane; it would also help preserve capitalism, because in a democracy, creative destruction cannot occur without some type of safety net. Workers who risk losing their jobs and lack any social support will soon vote an end to free markets.

Private Equity, Capitalism’s Secret Weapon

Created in the United States in 1946, private equity funds are collective investment schemes that didn’t become serious economic players until the 1970s in Silicon Valley. Early private equity investors, also known as venture capitalists, would buy shares in promising new industries like high-tech and sell their investments at a considerable profit. Eventually, private equity funds spread beyond Silicon Valley and invested in a wider range of industries. Today, they raise capital from cash-rich investors—pension funds, insurance companies, wealthy individuals—or borrow it from commercial banks and other financial institutions. Then they invest in various companies. The goal of the private equity fund is to sell those investments—often to another private equity fund—and turn a profit.

Smart investors at private equity funds select poorly managed companies whose value can be increased by extending, reducing, or reshuffling their activities. After buying a significant number of shares in such a company, a private equity fund can redirect or replace its management structure. Private equity managers may terminate redundant workers to increase productivity; scale back or eliminate less profitable departments; or use the company’s existing business to extend its brand and reach. For instance, Bain Capital, the private equity fund founded by Mitt Romney, turned Staples from a local brand into a national office supplier.

In the simplest sense, private equity investors reallocate capital where it will be most effective—from less productive uses to more profitable ones. Private equity funds propel capitalism’s creative destruction: by promoting innovation and punishing obsolescence, they fuel economic growth.

At the same time, by speeding up processes that might otherwise take a long time—such as the decline of an old industry and the emergence of a new one—private equity funds make the social costs of creative destruction more visible. Those who defend free markets, creative destruction, and private equity must do a better job of explaining their genuine benefits while supporting effective social policies to help workers make smoother transitions from old industries to new ones.

Schumpeter himself prophesied that the unpopularity of capitalism would eventually kill it. He doubted the capacity and willingness of the bourgeoisie to defend capitalism’s legitimacy, and he doubted the heirs of capitalist entrepreneurs even more. He knew many, both in his native Austria and in the United States, who squandered the capital that their parents and grandparents had accumulated and who were eager for the Left to forgive them for having inherited their wealth.

The ultimate enemies of capitalism, in Schumpeter’s view, were intellectuals, many of whom found it outrageous that businessmen had so much more money than they did. Envy—and the indisputable imperfections of capitalism—made these thinkers and writers, including some of Schumpeter’s Harvard colleagues, yearn for a better economic system. Ironically, the wealth created by capitalism had bankrolled a massive expansion of the educational system, empowering the intellectual class that hated that wealth. “Capitalism inevitably . . . educates and subsidizes a vested interest in social unrest,” Schumpeter noted. The rhetorical talent of the intellectuals, he predicted darkly, would help bring capitalism to its knees.

Schumpeter’s pessimism about capitalists’ heirs may have gone too far: some of them, especially in America, have put their money to good use in philanthropies, museums, and foundations that don’t lobby against capitalism. His characterization of intellectuals, though, remains as accurate today as when he made it decades ago. And while it’s true, of course, that socialism as Schumpeter feared it has all but disappeared, the Obama administration’s enthusiasm for economic intervention shows that American openness to creative destruction is not a given. Perhaps the most virulent opponent of creative destruction is the riotous antiglobalization movement. Perpetually laying siege to G-20 meetings, the antiglobalists refuse to accept—or fail to understand—that competition spurs innovation and that innovation spurs economic growth and human progress. Thanks to trade, market competition has become global, establishing a worldwide division of labor that dramatically reduces the costs of consumer goods, from food to cell phones and beyond. In the antiglobalists’ dreamworld, everything would become local again—a fantasy that, were it ever to become reality, would limit access to many goods to the wealthy alone.

Can a Schumpeterian candidate make it to the White House in 2012? Yes, but in the current climate of economic uncertainty, he will need to be a talented rhetorician. Otherwise, America in a second Obama term will probably continue to move in a European direction, with the government playing an increasingly activist role in the economy, protecting out-of-date ways of doing business. And without the liberating fire of creative destruction, America will follow Europe down the path of slow growth, high unemployment, and decline.


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