35. Creative Destruction

Note: This post is the thirty-fifth in a series. Click here for the full listing of the series.

I've talked a few times about the notion of trade being a win-win (pareto-efficient), and how the first welfare theorem of economics talks about how under conditions of perfect competition, nobody can be made better off without anyone being made worse off.

In my readings on economic topics, I find that people often therefore regard anything that interferes with perfect competition as a bad thing. Additionally, it is common to see people discuss markets as though they were in a mostly static state, where all that could vary was the price charged by a company, and that competition consisted solely of price competition¹. In this post I want to highlight how capitalism itself, at its core, depends, and is in some ways defined by beneficial breaches to conditions of perfect competition.

Weber covered this ground (as I discussed here), in contrasting the capitalist system with a traditionalist market based one, but the best known description comes from Joseph Schumpeter, who popularized the phrase 'Creative Destruction' in his book, 'Capitalism Socialism Democracy.'

Creative destruction is the process by which innovation (e.g. competition on some basis other than price) upsets the balance of a market. More accurately, it is not that innovation upsets a balanced competitive market, but rather that ongoing innovation prevents most markets from ever even approaching the notion of prefect competition in the first place.

Unlike the case of a typical trade which is a win-win for all involved, creative destruction is an inherently competitive process meaning that it creates both winners and losers.

As Wikipedia says with unusual eloquence,

Creative destruction can hurt. Layoffs of workers with obsolete working skills can be one price of new innovations valued by consumers. Though a continually innovating economy generates new opportunities for workers to participate in more creative and productive enterprises (provided they can acquire the necessary skills), creative destruction can cause severe hardship in the short term, and in the long term for those who cannot acquire the skills and work experience.'

The most famous example of people hurt by 'creative destruction', is the case of the Luddites who were (per Wikipedia),

a social movement of British textile artisans in the early nineteenth century who protested—often by destroying mechanised looms—against the changes produced by the Industrial Revolution, which they felt were leaving them without work and changing their entire way of life.

It wasn't just that they 'felt' that way, their way of life really was threatened by the innovation and price competition underway in their industry. You don't see a lot of textile artisans around nowadays.

Schumpeter is a great writer so here's a fairly lengthy excerpt to get the flavour of what his argument was:

Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action; this fact is important and these changes (wars, revolutions and so on) often condition industrial change, but they are not its prime movers. Nor is this evolutionary character due to a quasi-automatic increase in population and capital or to the vagaries of monetary systems, of which exactly the same thing holds true. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

As we have seen in the preceding chapter, the contents of the laborer's budget, say from 1760 to 1940, did not simply grow on unchanging lines but they underwent a process of qualitative change. Similarly, the history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today–linking up with elevators and railroads–is a history of revolutions. So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mailcoach to the airplane.

The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation–if I may use that biological term–that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.

. . .

Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull.

. . .

The first thing to go is the traditional conception of the modus operandi of competition. Economists are at long last emerging from the stage in which price competition was all they saw. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position. However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance)–competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives.

This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether competition in the ordinary sense functions more or less promptly; the powerful lever that in the long run expands output and brings down prices is in any case made of other stuff.

It is hardly necessary to point out that competition of the kind we now have in mind acts not only when in being but also when it is merely an ever-present threat. It disciplines before it attacks. The businessman feels himself to be in a competitive situation even if he is alone in his field or if, though not alone, he holds a position such that investigating government experts fail to see any effective competition between him and any other firms in the same or a neighboring field and in consequence conclude that his talk, under examination, about his competitive sorrows is all make-believe. In many cases, though not in all, this will in the long run enforce behavior very similar to the perfectly competitive pattern.

I haven't really made the connection with ethics clear so far, so a few comments on that may be in order. First of all, Jane Jacobs contrasted the desire for innovation under commercial ethics with respect for tradition, so this is another confirmation of that split.

Secondly, there is the recognition that the process of the market is not a pareto-optimal, win-win one where there are no losers and nobody has any real reason to complain, but rather is a competitive one where the essence of the system is people making voluntary transactions that have significant negative repercussions (externalities) for parties not part of the transaction (e.g. your boss and an Indian worker agree that your job will now be done in India).

The fact that we don’t suffer from more Luddite style violence, reflects that society makes an effort to assist those blown over by the gale of capitalism and, related, that a critical mass of people feel they have more to lose from fighting the system than by going along.

Also, the process of innovation itself relies heavily on the ethics that Jacobs outlined. Optimism to make one believe that the untried plan will work and a willingness to be thrifty and productive in order to save the resources that will be used to make the productive investments needed.



¹ In economics, but not in business books where simple models such as Porter’s Five Forces model present a more realistic assessment of the situation and discussion of pricing in the context of business strategy.

33. Prosperity Gospel vs. Austerity Gospel

A bit of a digression for this holiday season post...

Mike Konczal (of the blog Rortybomb), links toa pair of articles in The Atlantic on two different religious movements that involve questions of ethics, economics and debt:

The first is an article by Megan McArdle on Dave Ramsay, who preaches his gospel of living debt-free in evangelical churches and to the secular world as well:

"On a fine summer day at the end of August, I paid $220 for front-row seats on the floor of a minor-league hockey rink in Detroit, just to hear Ramsey talk for five hours. The ostensible topic: getting your financial life in order. Afterward, my fiancé, who grew up in the Bible Belt, called me to ask what I'd thought.

'I think I just attended my first prayer meeting,' I told him.

There was, of course, a great deal of talk about money, and what to do with it. But the format was more tent revival than accounting seminar, with the first 90 minutes or so mostly devoted to Ramsey’s personal story of ruin and redemption. We heard how, during the second half of the 1980s, a young Ramsey built up a multimillion-dollar real-estate empire—then lost it all as the bank got nervous and called his loans, ultimately forcing him and his wife into bankruptcy. How, searching for help in his hour of need, he turned to the Bible and discovered Proverbs 22:7: 'The rich rule over the poor, and the borrower is slave of the lender.' At that moment, he told an audience so hushed that we could hear the ice squeak, Ramsey decided to never borrow another dollar again."

The second is an article by Hanna Rosin on 'The Prosperity Gospel'

"That Sunday, Garay was preaching a variation on his usual theme, about how prosperity and abundance unerringly find true believers. 'It doesn’t matter what country you’re from, what degree you have, or what money you have in the bank,' Garay said. 'You don’t have to say, 'God, bless my business. Bless my bank account.' The blessings will come! The blessings are looking for you! God will take care of you. God will not let you be without a house!'

Pastor Garay, 48, is short and stocky, with thick black hair combed back. In his off hours, he looks like a contented tourist, in his printed Hawaiian shirts or bright guayaberas. But he preaches with a ferocity that taps into his youth as a cocaine dealer with a knife in his back pocket. 'Fight the attack of the devil on my finances! Fight him! We declare financial blessings! Financial miracles this week, NOW NOW NOW!' he preached that Sunday. 'More work! Better work! The best finances!' Gonzales shook and paced as the pastor spoke, eventually leaving his wife and three kids in the family section to join the single men toward the front, many of whom were jumping, raising their Bibles, and weeping. On the altar sat some anointing oils, alongside the keys to the Mercedes Benz."

Reading the two articles, I was struck by how the two different approaches picked up different elements from the commercial set of ethics that Jacobs described in Systems of Survival: Ramsay emphasizes thrift, and investing for productive purposes while the prosperity gospel emphasizes optimism and the promotion of comfort and convenience. Neither one really seems quite right on its own. Ramsay's approach would cutoff prudent borrowing to fund a business venture while the prosperity gospel seems to just encourage imprudent borrowing in the belief that God will provide one way or the other.

Anyway, it's some interesting reading.

26. The Protestant Ethic and the Spirit of Capitalism

Note: This post is the twenty-sixth in a series. Click here for the full listing of the series.

Other than Plato's 'Republic', the historical work that gets the most
discussion in Jane Jacob's 'Systems of Survival' is probably 'The Protestant Ethic and the Spirit of Capitalism' by Max Weber.

This isn't surprising since it turns out that Weber held a view quite similar to Jacobs':

"We will define a capitalistic economic action as one which rests on the expectation of profit by the utilization of opportunities for exchange, that is, on (formally) peaceful chances of profit. Acquisition by force (formally and actually) follows its own particular laws and it is not expedient , however little one can forbid this, to place it in the same category with action which is, in the last analysis oriented to profits from exchange."

In addition to distinguishing the ethics of force from the ethics of exchange, Weber also makes a clear (and somewhat unusual) distinction between capitalism and greed.

"The impulse to acquisition, pursuit of gain, of money, has in itself nothing to do with capitalism. The impulse exists and has existed among waiters, physicians, coachmen, artists, prostitutes, dishonest officials, soldiers, nobles, crusaders, gamblers and beggars. One may say that it has been common to all sorts and conditions of men at all times and in all countries of the earth, wherever the objective possibility of it is or has been given. It should be taught in the kindergarten of cultural history that this naive idea of capitalism must be given up once and for all. Unlimited greed for gain is not in the least identical with capitalism, and is still less its spirit. Capitalism may even be identical with the restraint, or at least a rational tempering of this impulse. But capitalism is identical with the pursuit of profit, and forever renewed profit

(bold face added).

Note the contrast with David Gauthier - where Gauthier viewed the perfect market as a morally free zone which allowed man to pursue his natural bent for 'more' without restraint, Weber sees capitalist activity as involving a restraint on the natural impulse for more, where the restraint serves to further the long term accumulation of capital. For Weber, there is a distinction between a rational calculation of how to accumulate as much capitals over time as possible, and an impulsive or irrational greed that can sabotage the accumulation of capital (although Weber later notes that there is a certain irrationality in just accumulating wealth without ever making any personal use of it).

Weber repeatedly makes the distinction between the man with a capitalist spirit and the 'adventurer' who seeks personal gain but by whatever means possible not within any specific capitalist approach.

"This kind of entrepreneur, the capitalistic adventurer, has existed everywhere. With the exception of trade and credit and banking functions, their activities were predominantly of an irrational and speculative character, or directed to acquisition by force, above all the acquisition of booty, whether directly in war or in the form of continuous fiscal booty by exploitation of subjects.

The capitalism of promoters, large scale speculators, concession hunters, and much modern financial speculation, even in peace time, but, above all, capitalism especially concerned with exploiting wars, bears this stamp even in modern countries. ...

But in modern times the Occident has developed, in addition to this, a very different form of capitalism which has appeared nowhere else: the rational capitalistic organization of (formally) free labour."

I think of this distinction Weber raises as the distinction between someone like Donald Trump - aggressive, ostentatious, frequently in bankruptcy, spendthrift, a promoter, large scale speculator and concession hunter - and Warren Buffett, mild mannered, legendary for his frugality and thrift, not particularly prone to self promotion, perennially focussed on increasing profits.


Much of the essay is devoted to Weber's notion that the restraint that serves the accumulation of capital, takes the form of a set of ethics that transforms a person's desires, as opposed to simply a technique that will best serve a person's pre-existing desires.

"The peculiarity of this philosophy of avarice appears to be the ideal of the honest man of recognized credit, and above all the idea of a duty of the individual toward the increase of his capital, which is assumed as an end in itself. Truly what is here preached is not simply a means of making one's way in the world, but a peculiar ethic. The infraction of its rules is treated not as foolishness but as forgetfulness of duty. That is the essence of the matter. It is not mere business astuteness, that sort of thing is common enough, it is an ethos. This is the quality which interests us." 

 (emphasis added)

Weber reinforces the point by looking at the writings of Benjamin Franklin, who was not particularly religious but was known as an exemplar of the early American dedication to the values of hard work and thrift.

"...all Franklin's moral attitudes are colored with utilitarianism. Honesty is useful, because it assures credit; so are punctuality, industry, frugality, and that is the reason they are virtues. A logical deduction from this would be that where, for instance, the appearance of honesty serves the same purpose, that would suffice, and an unnecessary surplus of this virtue would evidently appear to Franklin's eyes a unproductive waste.

And as a matter of fact, the story in his autobiography of his conversion to those virtues, or the discussion of the value of a strict maintenance of the appearance of modesty, the assiduous belittlement of one's own deserts in order to gain general recognition later, confirms this impression. According to Franklin, those virtues, like all others, are only in so far virtues as they are actually useful to the individual, and the surrogate of mere appearance always sufficient when it accomplishes the end view. It is a conclusion which is inevitable for strict utilitarianism. The impression of many Germans that the virtues professed by Americanism are pure hypocrisy seems to have been confirmed by this striking case. But in fact the matter is not by any means so simple. 
 
Benjamin Franklin's own character, as it appears in the really unusual candidness of his autobiography, belies that suspicion. The circumstance that he ascribes his recognition of the utility of virtue to a divine revelation which was intended to lead him in the path of righteousness, shows that something more than mere garnishing for purely egocentric motives is involved.  

In fact, the summumbonum of his ethic, the earning of more and more money, combined with the strict avoidance of all spontaneous enjoyment of life, is above all completely devoid of any eudaemonistic, not to say hedonistic, admixture. It is thought of so purely as an end in itself, that from the point of view of the happiness of, or utility to, the single individual, it appears entirely transcendental and absolutely irrational. Man is dominated by the making of money, by acquisition as the ultimate purpose of his life. Economic acquisition is no longer subordinated to man as the means for the satisfaction of his material needs. This reversal of what we should call the natural relationship, so irrational from a naive point of view, is evidently as definitely a leading principle of capitalism as it is foreign to all peoples not under capitalistic influence. At the same time it expresses a type of feeling which is closely connected with certain religious ideas. If we thus ask, why should "money be made out of men", Benjamin Franklin himself, although he was a colorless deist, answers in his autobiography with a quotation from the Bible, which his strict Calvinistic father drummed into him again and again in his youth: "Seest thou a man diligent in his business? He shall stand before kings" (Prov. xxii. 29). The earning of money within the modern economic order is, so long as it is done legally, the result and the expression of virtue and proficiency in a calling; and this virtue and proficiency are, as it is now not difficult to see, the real Alpha and Omega of Franklin's ethic"

So what virtues actually make up this ethic that Weber is describing? Weber never actually spells out (as far as I could tell) the specific virtues, but they can be easily extracted from various quotes.

A story Weber tells about how a 'traditionalistic' industry might be transformed to a 'capitalistic' one, captures many of the elements of the cpaitalist spirit.

"Until about the middle of the past century the life of a putter-out was, at least in many of the branches of the Continental textile industry, what we should today consider very comfortable. We may imagine its routine somewhat as follows: The peasants came with their cloth, often (in the case of linen) principally or entirely made from raw material which the peasant himself had produced, to the town in which the putter-out lived, and after a careful, often official, appraisal of the quality, received the customary price for it. The putter-out's customers, for markets any appreciable distance away, were middlemen, who also came to him, generally not yet following samples, but seeking traditional qualities, and bought from his warehouse, or, long before delivery, placed orders which were probably in turn passed on to the peasants. Personal canvassing of customers took place, if at all, only at long intervals. Otherwise correspondence sufficed, though the sending of samples slowly gained ground. The number of business hours was very moderate, perhaps five to six a day, sometimes considerably less; in the rush season, where there was one, more. Earnings were moderate; enough to lead a respectable life and in good times to put away a little. On the whole, relations among competitors were relatively good, with a large degree of agreement on the fundamentals of business. A long daily visit to the tavern, with often plenty to drink, and a congenial circle of friends, made life comfortable and leisurely. 

The form of organization was in every respect capitalistic; the entrepreneur's activity was of a purely business character; the use of capital, turned over in the business, was indispensable; and finally, the objective aspect of the economic process, the bookkeeping, was rational. But it was traditionalistic  business, if one considers the spirit which animated the entrepreneur: the traditional manner of life, the traditional rate of profit, the traditional amount of work, the traditional manner of regulating the relationships with labor, and the essentially traditional circle of customers and the manner of attracting new ones. All these dominated the conduct of the business, were at the basis, one may say, of the ethos of this group of business men.  

Now at some time this leisureliness was suddenly destroyed, and often entirely without any essential change in the form of organization, such as the transition to a unified factory, to mechanical weaving, etc. What happened was, on the contrary, often no more than this: some young man from one of the putting-out families went out into the country, carefully chose weavers for his employ, greatly increased the rigor of his supervision of their work, and thus turned them from peasants into laborers. On the other hand, he would begin to change his marketing methods by so far as possible going directly to the final consumer, would take the details into his own hands, would personally solicit customers, visiting them every year, and above all would adapt the quality of the product directly to their needs and wishes.

At the same time he began to introduce the principle of low prices and large turnover. There was repeated what everywhere and always is the result of such a process of rationalization: those who would not follow suit had to go out of business. The idyllic state collapsed under the pressure of a bitter competitive struggle, respectable fortunes were made, and not lent out at interest, but always reinvested in the business. The old leisurely and comfortable attitude toward life gave way to a hard frugality in which some participated and came to the top, because they did not wish to consume but to earn, while others who wished to keep on with the old ways were forced to curtail their consumption.  

And, what is most important in this connection, it was not generally in such cases a stream of new money invested in the industry which brought about this revolution -- in several cases known to me the whole revolutionary process was set in motion with a few thousands of capital borrowed from relations -- but the new spirit, the spirit of modern capitalism, had set to work. The question of the motive forces in the expansion of modern capitalism is not in the first instance a question of the origin of the capital sums which were available for capitalistic uses, but, above all, of the development of the spirit of capitalism. Where it appears and is able to work itself out, it produces its own capital and monetary supplies as the means to its ends, but the reverse is not true. Its entry on the scene was not generally peaceful. A flood of mistrust, sometimes of hatred, above all of moral indignation, regularly opposed itself to the first innovator. Often -- I know of several cases of the sort -- regular legends of mysterious shady spots in his previous life have been produced. It is very easy not to recognize that only an unusually strong character could save an entrepreneur of this new type from the loss of his temperate self-control and from both moral and economic shipwreck. Furthermore, along with clarity of vision and ability to it is only by virtue of very definite and highly developed ethical qualities that it has been possible for him to command the absolutely indispensable confidence of his customers and workmen. Nothing else could have given him the strength to overcome the innumerable obstacles, above all the infinitely more intensive work which is demanded of the modern entrepreneur. But these are ethical qualities of quite a different sort from those adapted to the traditionalism of the past.  

(emphasis added)

Here we see the innovation, hard work, competitiveness, openness to new ways of doing things, frugality, and productive investment of the capitalist spirit contrasted with the leisure, respect for tradition and non-competitiveness of the old ways of business.

Weber notes the somewhat internally contradictory nature of the capitalist spirit in that on the one hand, pursuing it properly leads to the accumulation of wealth, yet the same spirit generally forbids spending that wealth on any sort of luxury or self-gratification that might justify (in rational terms) the work and hardship that went into accumulating it.

"This worldly Protestant asceticism, as we may recapitulate up to this point, acted powerfully against the spontaneous enjoyment of possessions; it restricted consumption, especially of luxuries. On the other hand, it had the psychological effect of freeing the acquisition of goods from the inhibitions of traditionalistic ethics. It broke the bonds of the impulse of acquisition in that it not only legalized it, but (in the sense discussed) looked upon it as directly willed by God. The campaign against the temptations of the flesh, and the dependence on external things, was, as besides the Puritans the great Quaker apologist Barclay expressly says, not a struggle against the rational acquisition, but against the irrational use of wealth.  

But this irrational use was exemplified in the outward forms of luxury which their code condemned as idolatry of the flesh, however natural they had appeared to the feudal mind. On the other hand, they approved the rational and utilitarian uses of wealth which were willed by God for the needs of the individual and the community. They did not wish to impose mortification on the man of wealth, but the use of his means for necessary and practical things. The idea of comfort characteristically limits the extent of ethically permissible expenditures. It is naturally no accident that the development of a manner of living consistent with that idea may be observed earliest and most clearly among the most consistent representatives of this whole attitude toward life. Over against the glitter and ostentation of feudal magnificence which, resting on an unsound economic basis, prefers a sordid elegance to a sober simplicity, they set the clean and solid comfort of the middle-class home as an ideal." 

Finally, although Weber tries to keep his own opinions out of it, his concerns about the effect of the capitalistic spirit do occasionally show through, especially in a passage near the end of the essay where he bemoans how once this spirit was a choice but now there is no choice but to adopt it,

"The Puritan wanted to work in a calling; we are forced to do so. For when asceticism was carried out of monastic cells into everyday life, and began to dominate worldly morality, it did its part in building the tremendous cosmos of the modern economic order. This order is now bound to the technical and economic conditions of machine production which today determine the lives of all the individuals who are born into this mechanism, not only those directly concerned with economic acquisition, with irresistible force. Perhaps it will so determine them until the last ton of fossilized coal is burnt."

The last line is interesting. Weber imagines that the capitalist spirit's drive for more and more will be unstoppable until it literally runs out of energy in the sense that there is no more natural support for further expansion of human activity. People largely moved on to oil and gas before we ran out of coal (although we've used up a lot of the best supplies of coal available to us, and continue to use more, all the same) but with peak oil a current topic of discussion, Weber's comment is as timely as ever.

Are those who see an end to our way of life because of peak oil (or global warming) simply looking for a saviour from the capitalistic treadmill we are unable to take ourselves off without outside 'help', or are cornucopians who see no real danger of running out of any resources or hitting any environmental constraints simply dismissing anything which might derail the capitalistic train that is driving progress and which we would be crazy to want to get off?


But back to the main point, which is that Weber viewed successful capitalism as involving a set of ethical restraints on behaviour. Where David Gauthier simply assumed that man always wanted more and that whatever action he took automatically reflected that desire for more, Weber sees that actually achieving a certain kind of more (more profits and wealth) required a form of ascetism and a set of ethics that privileges one set of desires (the desire for accumulation) ahead of another (the desire for consumption and ostentation).

This is how Warren Buffett, whose license place says 'Thrifty' is now one of the world's richest men while Donald Trump, whose license plate has his own initials, repeatedly ends up in bankruptcy.


---
Note: All quotes from the Talcott Parsons translation, first published in 1930 as viewed here or here.