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 1800s 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, lets 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.
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.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Corporate Finance - Introduction
- Nominal and Real Value of Money
- Fundamental Rules of Corporate Finance
- Present and Future Value of Money
- Net Present Value Calculations
- Compounding Intervals and Interest Rate
- What Are Negative Interest Rates ?
- The Consequences of Negative Interest Rates
- Opportunity Cost of Capital
- Valuing Cash Flows in Different Periods
- What is Perpetuity ?
- Growing Perpetuity
- What is Annuity ?
- Ordinary Annuity vs. Annuity Due
- Types of Annuity Calculations
- What is Bond Valuation ?
- Bond Market Conventions
- How Interest Rates Affect Bonds ?
- Stock Valuation Models
- Discounted Cash Flow Approach
- Assumptions During Stock Valuation
- What is Cost of Equity ?
- What is Payback Period ?
- What is Internal Rate of Return (IRR) ?
- Problems With Using IRR
- Capital Rationing & Profitability Index
- Types of Capital Rationing
- Capital Controls: Meaning, Types, Benefits and Downside
- Estimating Project Cash Flows: Part 1
- Estimating Project Cash Flows: Part 2
- Estimating Project Cash Flows: Part 3
- Capital Budgeting and Inflation
- Capital Budgeting and Depreciation
- Equivalent Annual Costs
- Investing and Financing Decisions
- Getting Creative with Capital Budgeting
- The Fallacy of Creative Destruction
- Companys Risk vs. Project Risk
- How Governments around the World are Bankrupting Future Generations for Present Consumption
- Role of Credit Rating Agencies in Determining Attractiveness of Companies and Countries
- Federal Reserve Announcement to Taper Quantitative Easing
- How Do Funds Transfer Systems Work
- The Importance of KYC (Know Your Customer) Norms and Procedures in Banking
- Difference between Corporate, Retail, Investment Banking, and Private Banking
- Impact of Geography on Banking and its Functions
- Functions of a Central Bank in Modern Economies
- Lease Rental Discounting
- Lending Against Intangible Assets
- Real Reasons behind FDI in Retail in India
- Microfinance: A Cure for Poverty
- Microfinance: Indebting the Poorest in the World
- Behind the Scenes of an Initial Public Offer (IPO)
- Pros and Cons of Going Public
- Snapchat IPO: Is this the New Tech Bubble ?
- Benefits of Delaying Profitability
- Why Do Corporations Get Away With Tax Avoidance ?
- After Effects of the Nirav Modi Scam
- The Panaya Acquisition
- The Flipkart and Wal-Mart Alliance
- The Worlds Largest IPO
- Initial Coin Offerings: A Primer
- The Aftermath of the Qualcomm Deal
- What are Demergers: Its Pros and Cons
- Benefits of a Holding Company
- The Economics of Lawsuits
- Protectionist Sentiment over Flipkart Takeover
- The Impact of Tariffs on the Energy Sector
- Venture Debt A Primer
- Interest Rates and Automobile Sales
- How Should Companies Communicate With Wall Street?
- How an Interest Rate Hike Will Affect the Government of USA
- Is Tesla Close to Bankruptcy?
- Myths Surrounding Toys R Us Bankruptcy
- The Economics of 'Soda Taxes'
- Why Elon Musk's Tesla Should Go Private and Why It Won't?
- Why the Xiaomi IPO Failed?
- How A Whatsapp Message Nearly Took Down A Company
- The Case for Index Funds
- The Sears Bankruptcy
- The Socialization of Losses
- The Sudden Downfall of IL&FS
- Why Healthy Corporate-Regulator Tussle is Good for Free Market Capitalist Economies
- What Happens When Businesses Go Bankrupt? Insolvency, Aftermath, and Recovery
- Alibabas Singles Day
- Ubers New Businesses
- Goldman Sachs and the 1MDB Scandal
- The Amazon Divorce
- Are Index Funds Not A Good Investment In India?
- Can Brick And Mortar Stores Compete With Amazon?
- Why is the Fed Still Raising Interest Rates?
- Problems Related to Facebook, WhatsApp, and Instagram Mega Merger
- The Whatsapp-Facebook-Instagram Merger
- What Is The DHFL Scam?
- Financial Troubles In the Fracking Industry
- Flipkart Circumvents Indias FDI Norms
- Subprime Automobile Loans in America
- The Jaguar Land Rover Debacle
- The Kraft - Heinz Fallout
- Why Uber Should Be Regulated?
- Is Regulation of the Tech Sector Long Overdue with the Tech Giants being Too Big
- The Fall of An Ambani Scion
- Litigation Funding: A Primer
- The Finance behind the Plastic Problem
- The MasterCard Visa Duopoly
- Is the Lyft IPO Overpriced?
- The Alliance between Car Companies and Ride Hailing Apps
- The Amazon Divorce Deal
- The Lawsuit Between Spotify and Apple Corporation
- The Story Behind the L&T- Mindtree Takeover Bid
- Do IPOs Affect Competitive Firms?
- Can Cost Cutting Turn Out To Be Expensive?
- The Economic Impact of Facebook Outage
- The Apple-Qualcomm Legal Battle
- Cross Border Credit Reporting
- The Sudden Deluge of Unicorn IPOs
- The Wow Airline Debacle
- The WeWork Business Model
- Problem with Private Securities Offerings
- The Amazon FedEx Breakup
- The Decline of the Big Corporation
- The Gap-Old Navy Breakup
- Apples Acquisition of Intels Modem Business
- Mergers and Acquisitions: A New Perspective
- The CBS-Viacom Merger
- Why are Corporations Hoarding Trillions in Cash?