“Creative destruction” and why it stimulates innovation and prosperity

A person born in 1600 would find the world of 1800 quite familiar. But someone born in 1800 would find today’s world beyond comprehension. What explains this transformation? The answer is: market capitalism.

Why has market capitalism turned out to be so dynamic? The answer is, it contains within it a powerful engine for change. It’s not just economic freedom, although that matters. It’s not science and technology either, although that matters too. This is what the great Austrian economist Joseph Schumpeter called “creative destruction”.

Philippe Aghion, professor at the Collège de France and at the London School of Economics, has had a brilliant career in bringing Schumpeter’s model into the rigorous theoretical and empirical world of modern economics. In this important work, written with two collaborators, Céline Antonin and Simon Bunel, he introduces his work to the general public.

The result, The power of creative destruction, is lucid, empirically grounded, broad and well argued. It is also rather dry. But it gives a nice overview of the field. As the authors explain, the model of growth by creative destruction has three components.

First, “innovation and the diffusion of knowledge are at the heart of the growth process”. Growth is cumulative, as today’s innovators rest on the shoulders of all the scientists and technologists who came before them.

Second, innovators are motivated by the possibility of a lucrative monopoly. These rents must be protected by property rights, including intellectual property rights.

Finally, innovation threatens the incumbent operators, who will fight to repress it. Thus, “On the one hand, rents are necessary to reward innovation; on the other hand, yesterday’s innovators should not use their rents to hinder new innovations. Again, assessing today’s debate on why growth has consistently disappointed, the authors argue that a competition policy that protects entrants from incumbent firms is essential.

The book reports a great deal of empirical research, most of it recent, that shows how creative destruction works in practice. It shows, for example, that new businesses create a large part of new jobs. A lot of those businesses and those jobs disappear. But the more intense this Darwinian process, the faster the economy grows.

The authors also note the distinction between “catch-up” economies, such as China, and border economies, such as the United States. In the first case, growth is more about investing in existing ways of doing things. But border economies can only grow by innovating. If the incumbents are allowed to block competitors, a border economy is doomed to stagnate.

Graph showing the share of total electricity generated by major energy sources in the US manufacturing sector (%)

Regarding the well-known “middle income” trap, the book argues that the main failure of these countries is to create the institutions that foster cutting-edge innovation. He also argues that under the current circumstances, in which sophisticated services can be technologically dynamic and marketed internationally, it might be possible to develop without industrializing, as India has done.

Innovation also depends on the trajectory: incumbent companies build on what they know, while new entrants are ready to start from scratch. If governments are to ensure rapid innovation in new directions, they must motivate new actors who are not trapped by past successes.

This is why the emergence of new industrial sectors almost always means the emergence of new companies. For this reason, a necessary condition for creative destruction is a financial system capable and willing to invest in new ventures. The book explains how the United States benefits from a skilled venture capital industry, which knows how to nurture start-up companies, and a large base of institutional investors, who will support these companies as they grow. .

The authors also argue that the impact of creative destruction is complex. Additional competition boosts innovation and productivity in pioneering firms, but kills weaker ones. New fortunes tend to increase higher incomes, compounding this aspect of inequality. But, they note, this is far better than the higher inequality created by lobbying to thwart competitors.

On the great environmental challenges of our time, the authors insist that “degrowth” (a popular cause nowadays) is practically and politically impractical. We can only innovate to get out of our dilemmas. But the right kind of innovation won’t happen without the guidance of incentives, regulation, public spending, and pressure from civil society.

Globalization is another delicate issue. The book concludes that protection is not the right answer to increased competition from imports. The best answer is to support innovation and thus promote new and dynamic companies over older and uncompetitive ones. Yet the political acceptability of this depends on the existence of a safety net that is not tied to specific jobs.

More broadly, there is no compromise between creative destruction and basic security for the population. On the contrary, people will be more willing to accept the first if they like the second. The Danish model of ‘flexicurity’ is, they suggest, the best approach.

Fundamentally, the success of creative destruction depends on the existence of an efficient, uncorrupted, law-ruled, and competitive state. This is only possible in a constitutional democracy, with an active civil society, independent institutions and free media.

Graph showing research productivity and the number of researchers in the pharmaceutical sector (index, 1970 = 1)

Such a state plays a central role as a macroeconomic stabilizer, a funder of basic science, a promoter of applied research and development, an investor in risky new technologies, a financier of education and social insurance, and a promoter of free competition.

It is, in short, a subtle analysis of what has made capitalism such an incomparably successful, but also disruptive, economic system. The success of the system depends on striking a balance not only between competitive economics and social stability, but also between letting capitalism tear itself apart and protecting it from predatory capitalists.

Schumpeter himself feared that capitalism would perish. So far, he seems to have been wrong. Another possibility is that democracy will die, because plutocracy allies itself with demagoguery. Either way, the civilizations of contemporary high-income democracies would perish. By promoting better understanding, this book could, with wisdom and luck, help us avoid this fate.

The power of creative destruction: Economic upheavals and the wealth of nations, by Philippe Aghion, Céline Antonin and Simon Bunel, translated by Jodie Cohen-Tanugi, Belknap Press, RRP $ 35 / £ 28.95 / € 31.50, 400 pages

Martin Loup is the chief economic commentator of the FT

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