Schumpeter, Creative Destruction, and your Portfolio Recovery Plan

With "government stimulus" dominating most of the discussion in the pages and on the screens of the financial media right now, we would advise investors to focus their attention in an entirely different direction, towards an area of enormous importance that is all too often overlooked.

Investors should carefully consider the critical importance of innovation and the entrepreneurial spirit. The real engine of economic growth in a free economy has always been and will continue to be this spirit of innovation -- of creating completely new ways of adding value to consumers or to other businesses.

The economist most closely associated with this concept and with first articulating it most clearly is the Austrian-born emigrant to the United States, Joseph A. Schumpeter (1883 - 1950), pictured above. Of the most influential three Austrian economists (Hayek, von Mises, and Schumpeter), Schumpeter is perhaps the least familiar, yet his focus on the critical role of entrepreneurial innovation should make him mandatory reading for all investors.

Schumpeter elaborated at length about this topic in a section of his book Capitalism, Socialism and Democracy entitled "Can Capitalism Survive?" There, he explains that capitalism "is by nature a form or method of economic change and not only never is but never can be stationary."

He explains that in any given industry growth does not take place in a linear fashion but rather in a series of "revolutions," saying "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." He goes on to give another example from the steel industry, concluding that it "illustrates the same process of industrial mutation" 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."

The importance of this concept of entrepreneurial "Creative Destruction" simply cannot be overlooked. Schumpeter is arguing that free enterprise, by its very nature, invites innovators to create radical new advances which overturn the previous paradigm, and that this process not only does not stop -- it cannot stop. We have touched on this subject in previous posts such as "Look for Paradigm Shifts" and "The Unstoppable Wave."

And yet the amazing thing to note is that much of economics (and much of investing since the arrival of so-called "modern portfolio theory") is dominated by mathematical formulas and models which purport to explain what will happen next -- completely oblivious to the fact that Schumpeter's "incessant revolutions" of "Creative Destruction" can never be predicted or incorporated into a bunch of mathematical economic models!

It is far better to heed the insight of Schumpeter, and then to see investing as a process of providing capital to fuel innovation. By doing so, the investor has the opportunity to participate in and to share the rewards of such revolutionary innovation!

This concept is at the heart of the investment philosophy that we have tried to explain from many different angles in our previous posts. It is the opposite of the concept of "playing the markets" or "tying up your money on Wall Street" that most people incorrectly believe to be synonymous with "investing."

From the perspective of investors who are standing in the current uncertain environment and looking forward to try to discern what the next decades will bring, it may seem as though increased government activity and intervention threatens to crush the spirit of innovation and entrepreneurship that we are discussing.

However, remember that Schumpeter said that capitalism simply cannot stand still, and in fact as we look back over previous decades (even decades as stifling as the 1930s and the 1970s) we must concede that this kind of revolutionary progress within businesses was taking place in different industries even during dark times.

Innovation may have a harder time, and be harder to find, in one time period than in another, based on a variety of circumstances, but it is a fact that it is always there if you look for it hard enough. And that is exactly what investors should be doing right now.

For later posts dealing with this topic, see also:

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