Schumpeterian economic development and financial innovations: a conflicting evolution

What is it about?

Abstract: Although in the Schumpeterian process of entrepreneurial innovations money and financial markets are assumed to affect economic development, Schumpeter does not explicitly study financial evolution and its effects on real dynamics. In order to fill this gap, this article suggests a Minsky-inspired interpretation of Schumpeterian institutional dynamics in monetary terms. It then develops a specific Schumpeterian analysis of the evolution of financial institutions and regulatory mechanisms in the wake of the 2007–08 crisis and points to major consequences of financial innovations on economic stability. It appears that unlike the creative destruction process of entrepreneurial innovations, in a liberalised/deregulated environment financial innovations move banks from their crucial role of financing long-term economic evolution and lead to reckless finance. Thus, financial market dynamics put economies on a destructive path. Such an evolution calls for active and tight rational regulation in order to shape capitalist finance towards more stable and welfare-enhancing strategies. Keywords: Economic development, Financial innovation and instability, Institutions and regulation, Monetary capitalist economy, Schumpeterian evolutionary dynamics JEL Classification: B25, B52, G01, G18, O16

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Why is it important?

Contrary to Schumpeterian entrepreneurial innovations, financial innovations mainly rely on short-sighted profitability and generate debt-funded speculative excesses – banks becoming disconnected from the long-term evolution of the real economy. Consequently, when the regulatory environment is shaped too loosely following liberal policies, financial dynamics may provoke destructive evolution. Though very intuitively, Schumpeter notices that capitalism is not a self-adjusting system and needs public intervention and control mechanisms –rational regulation – an intuition that Minsky, a PhD student of Schumpeter, has wisely developed against all odds in his entire work. According to the dominant economic theory a loosely regulated institutional environment leads to stronger financial competition and efficiency that result in innovations providing agents with a rich set of wealth-improving financial products/processes. The prevailing orthodoxy mainly relies on self-adjusting free market ideology and assumes that instabilities come from exogenous shocks or from inconsistent government policies. Recurrent financial crises nevertheless require a profound reappraisal of those assertions as it does not seem any more suitable to suppose religiously that free financial innovations necessarily lead to positive economic changes without questioning the relevance of the institutional design of regulatory mechanisms. To support this critique and apprehend the consequences of financial innovations on systemic stability, this article suggests a specific Schumpeterian analysis of capitalist finance evolution in a Minskyian vein. Although intuitively, Schumpeter maintains that in order to understand economic development, one should comprehend the evolution of monetary and financial institutions. The article then analyses the nature of financial innovations in a liberalized/deregulated environment and argues that unlike the entrepreneurial innovations creative destruction, financial innovations may lead to reckless finance and turn out to be a destructive creation process. This article also aims at contributing to a possible ‘cure’ of what Hodgson (2009) calls ‘the sickonomics’ (the standard macroeconomic theory/policy that failed to prevent the current crisis from occurring and destroying several million jobs all around the world) by suggesting some policy orientations to regulate capitalist finance.