The Fallacy of Creative Destruction

There is a widely held view that creative destruction is the cause of all business cycles. This explanation is used to convince people that business cycles are a good phenomenon. On the other hand, this explanation does not provide any insight as to why business cycles have been there only for a couple of centuries at maximum. Before 1800’s the concept of business cycles did not exist even though the concept of capitalism and free enterprise did exist.

In this article, we will have a closer look at why the belief that creative destruction causes business cycles is fundamentally flawed.

What is Creative Destruction ?

Creative destruction is a term coined by famous economist Joseph Schumpeter. He was of the opinion that capitalism is dynamic. It can never be stationary. The very purpose of capitalism is to find newer, better and more efficient ways to produce or transport goods.

To understand the concept better one has to imagine a mature market. A mature market has experienced firms that provide employment to a large number of people. Creative destruction means that every few years, a new technology will create a new market parallel to this mature market.

In the beginning, the newer market is much smaller than the mature market. This is because the consumers take the time to switch from an old technology to more modern technology. However, over a period of time, this switch does happen. In the course of this switch, the newer markets become bigger and more powerful gradually whereas the older markets become bankrupt. This bankruptcy and the subsequent boom have been termed as the process of creative destruction. The idea is that creative destruction is good for the economy. This is because in the short run it creates destruction. However, in the long-term, it creates a much better and more efficient utilization of resources.

Historical View of Creative Destruction

Schumpeter has created this theory of creative destruction to interpret any past event in the light of this destruction. Economic historians have then argued that this is the phenomenon that has been driving economic growth during known periods of economic history. For instance, the printing press is said to be a work of creative destruction and so are the other machines during the industrial revolution. The railroads are also said to have caused creative destruction. Later, the oil industry, iron, and steel and automobile are all said to have created wealth through this same process of creative destruction.

Confusion between Cause and Effect

The mainstream economists agree with the above-stated fact. However, this theory has also been open to several criticisms. One of the biggest ones is that cause and effect are being confused with this theory. The theory of creative destruction argues that changes in technology drive the general boom and bust phenomenon. Critics argue that causality works in the exact opposite direction. This means that instead, it is the general boom that creates technological changes and market disruptions. Some of these disruptions are good for the economy whereas other disruptions are bad. The Technological boom is not the cause of the business cycles. Instead, it is itself caused by the business cycle. For a better explanation, let’s look at the points below:

Savings is the Key Factor, Not Technology

Technology is not developed out of thin air. If substantial resources are devoted to any problem, science can figure out a solution. This is also the case with technological developments for business. If significant resources are spent on finding a solution, a newer and better way is usually found. Hence, the problem is not technology. Instead, the real problem is providing substantial resources that enable technology to move forward. Under normal circumstances, people have first to save enough money to channel that towards investments in technology. However, in modern credit driven society, money is created out of thin air. It is this abundance of money that fuels innovation. Prima facie, this may seem to be a good thing.

Wrong Price Signals

Credit creation fills the economy with the money supply. As a result, there is a general feeling of irrational exuberance. Consumer spending spree fuelled by a rise in consumer credit creates wrong price signals. The price of goods and services appear to be different than they would be in the absence of credit. Prices are the primary barometer for market innovation. When market prices go haywire, so does the innovation. Resources get directed towards solving wrong problems or problems which are not that important.

Malinvestments

The correct theory, therefore, is as follows: Credit creation leads to a growth in credit without there being a growth in savings. As a result, people have artificial purchasing power which will inevitably reduce whenever the credit creation is stopped. However, during the boom period purchasing power leads to wrong price signals. These wrong price signals forms the basis for investment decisions. As a result, wrong investment decisions are made. This leads to resources being squandered over economic problems which are not important. This entire process can be called malinvestment.

To sum it up, the theory of creative destruction provides a biased and distorted view of the world in order to make the business cycles appear in the positive light.