Why Do We Need a New Paradigm to Explain the Wealth of Nations?
The Power of Creative Destruction: Economic Upheaval and the Wealth of Nations, available in paperback, draws on cutting-edge theory and research to examine today’s most fundamental economic questions. In the following excerpt, authors Philippe Aghion, Céline Antonin, and Simon Bunel break down the reasoning for a new economic paradigm and define the core ideas behind the theory of creative destruction.
Out now is also The Economics of Creative Destruction: New Research on Themes from Aghion and Howitt, presenting the latest cutting-edge work on economic growth and innovation.
The answer is simple: existing paradigms have proved inadequate to explain major trends and to solve the enigmas of growth and the wealth of nations. For both theoretical and empirical reasons, it has become urgent to introduce a new paradigm.
The theoretical reason. Up to the late 1980s, the dominant theory of economic growth, known as the neoclassical model, was one of a growth process based on capital accumulation. The most elegant version of the neoclassical model was developed in 1956 by Robert Solow, whose work was awarded the Nobel Prize in 1987.
The simplicity and elegance of Solow’s model make it the necessary starting point for any course on economic growth. In a nutshell, it describes an economy in which production requires capital, and where growth of GDP comes from increasing the stock of capital. What causes the stock of capital to grow? The answer is households’ savings, which are presumed to be equal to a constant fraction of production (that is, of GDP).
It would seem that all is well in this economy: more capital, financed by savings, increases GDP, which leads to more savings and therefore more capital, further increasing GDP, and so forth. In other words, this economy seems to generate durable growth even in the absence of technical progress, merely as a result of capital accumulation.
The problem with this model lies in the fact that there are decreasing returns on producing solely with capital. The greater the number of machines, the less GDP increases by adding one more machine. At some point, the economy runs out of steam and stops growing. As Robert Solow explained very clearly, generating sustained growth necessitates technical progress that makes it possible to improve the quality of machines — in other words, their productivity. But Solow did not describe the factors that determine technical progress and in particular the factors that stimulate or inhibit innovation.
The empirical reason. Neoclassical theory does not explain the determinants of long-term growth, as we have just seen. Even less does it enable us to understand a whole set of enigmas related to growth, for example, why some nations grow more quickly than others, and why some nations converge to the levels of GDP per capita of the developed world and others remain far behind or stall along the way.
Thus, both theoretical and empirical considerations motivated the introduction of a radically new framework.
The model of growth through creative destruction is also known as the Schumpeterian paradigm because it was inspired by three ideas put forward by the Austrian economist Joseph Schumpeter but that had never before been formalized or tested.
The first idea is that innovation and the diffusion of knowledge are at the heart of the growth process. Long-term growth results from cumulative innovation, in that each new innovator “stands on the shoulders of giants” who preceded him. This idea echoes Solow’s conclusion that technical progress is a prerequisite of long-term sustained growth. Only with the diffusion and codification of knowledge can innovation be cumulative, without which we would have to continually reinvent the wheel and, like Sisyphus, climb the same mountain over and over.
The second idea is that innovation relies on incentives and protection of property rights. Innovation comes from the decision to invest, especially in research and development (R&D), by entrepreneurs motivated by potential returns — innovation rents. Anything that secures those rents, in particular protecting intellectual property rights, will incentivize entrepreneurs to invest more in innovation. And on the contrary, anything that jeopardizes rents, such as the absence of protection against imitation or confiscatory taxes on revenues from innovation, will discourage investment in innovation. More generally, innovation responds to positive or negative incentives from institutions and public policy: innovation is a social process.
The third idea is creative destruction: new innovations render former innovations obsolete. In other words, growth by creative destruction sets the stage for a permanent conflict between the old and the new: it is the story of all incumbent firms, all the conglomerates, that perpetually attempt to block or delay the entry of new competitors in their sectors.
Creative destruction thus creates a dilemma or a contradiction at the very heart of the growth process. On the one hand, rents are necessary to reward innovation and thereby motivate innovators; on the other hand, yesterday’s innovators must not use their rents to impede new innovations. As we mentioned above, Schumpeter’s answer to this dilemma was that capitalism was condemned to fail precisely because it was impossible to prevent incumbent firms from obstructing new innovations. Our response is that it is indeed possible to overcome this contradiction, in other words to regulate capitalism or, to take the title of Raghuram Rajan’s and Luigi Zingales’ 2004 book, to “save capitalism from the capitalists.”