Lessons to remember as we rebuild our economy

Mon, May 21, 2012, 01:00

INNOVATION TALK:‘ECONOMIC PROGRESS, in capitalistic society, means turmoil,’ stated the Austrian-Hungarian economist Joseph Schumpeter in his Capitalism, Socialism and Democracy, first published in 1942.

While Marx had identified economic depressions as the fatal flaws in a capitalistic system, Schumpeter instead viewed depressions as vital for the health of capitalism. He explained that economic prosperity results from economic growth, as new products and technology are introduced.

However, ultimately exuberance emerges as some firms overreach, and credit is overly generous. The cycle then reverses, growth diminishes, and poorly managed firms fail. Schumpeter believed that depressions cleanse an economy, laying the foundation for subsequent further growth via healthy and well-managed firms. Schumpeter identified a further form of economic turmoil: the damage caused to some firms by the creativity of others. “Creative destruction” results from a continuous process of competition and improvement in turn destroying weaker firms. He believed that the core engines of economic growth are not in fact economic, but social and institutional. In particular he asserted that the heart of capitalism is innovation. Few people are capable of identifying the commercial opportunities for new inventions, but entrepreneurs find and exploit them for private gain. Unlike classical economics in which investments can only come from past savings, Schumpeter observed that entrepreneurs (frequently) do not save or accumulate goods before they produce, but borrow other people’s money to build their firms.

He thus classified entrepreneurial endeavours as personally risk-free, since the direct economic risk is carried by the investors rather than the entrepreneur who only carries a reputational risk. Successful entrepreneurs personally gain, but Schumpeter observed that society at large also subsequently wins. He observed that almost all increases in society’s standards of living are due to innovation by entrepreneurs.

As we battle with our own economic depression and as we debate austere strategies to manage Europe back to growth, one wonders whether Schumpeter’s economic cycles and his assertion of the necessity of creative destruction are both inexorable. He would doubtless have tried to encourage us today by anticipating a new surge of entrepreneurship and innovation to reverse the current cycle and generate a fresh wave of growth. Some of us are indeed experiencing a renaissance in the Irish economy via a vibrant revival in the information and communications technology, agri-food and biosciences sectors. But in rebuilding our economy, we should consider what are the appropriate policies and mechanisms to nurture sustainable growth, private reward and societal benefit.

The Celtic Tiger era arguably was one in which most (but certainly not all) of society benefited concurrently with certain risk-takers. A few property financiers bought a competitive advantage for themselves by the trivial tactic of borrowing money from other people: they obtained cheap European debt and re-lent it to Irish property speculators, and kept on borrowing more and more so as to maintain their leadership position in lending to the Irish market. Meanwhile, the established banks struggled to catch up by mimicry: their conservative executive teams came under shareholder and board pressure to compete, or step out of the way and resign. The economy surged, the risk-takers personally benefited but so also did much of society, at least in the short term. An acquiescent, compliant and complicit political leadership cheered on from the sidelines, supremely grateful for the adulation of a largely content populace.

The tragedy of the demise of the Celtic Tiger is that the few key entrepreneurs involved borrowed other people’s money to such an extent that the political leadership of the day ultimately and very belatedly were coerced to intervene, under pressure to defend the global perception of the European banking system, and thus placed the entire Irish nation at extreme risk. When Lehman and other US financial institutions failed and global credit reduced, this end of the economic cycle almost destroyed the Irish banking system.

Schumpeter observed: “Nothing is so retentive as a nation’s memory.”

Future Irish generations will remember us and the Celtic Tiger.