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 / Summer 2007 / Issue 47(originally published by Booz & Company)


Nondestructive Creation

Nobel laureate Edmund Phelps says that Joseph Schumpeter was wrong: Entrepreneurship can generate stable growth.

Illustration by Lars Leetaru
Edmund (Ned) Phelps, best known for his work on macroeconomics, has never taught at a business school. Nonetheless, the work that earned him the Nobel Prize in Economics in 2006 is sure to shine a new light on business education, and to illuminate basic business practice as well.

Previously, the prevailing economic view of entrepreneurship (and the prevailing view of public policies related to entrepreneurial innovation) had centered on Joseph Schumpeter’s famous concept of “creative destruction.” Schumpeter described entrepreneurship as an uncoordinated activity, one conducted without central direction or planning, in which the entrepreneur is not a “rational economic calculator” (like the businessperson of neoclassical economic theory) but instead a relatively unfettered and unpredictable force. The entrepreneur’s contribution to society was seen as a kind of unavoidable pain. Like a forest fire that sweeps out old underbrush and makes room for hardier new growth, an entrepreneur, Schumpeter said, competes with established (and often moribund) businesses, undermining their business models in favor of newer, more effective, and more resilient technologies, products, and services. Even with that valuable net result, the Schumpeterian view has led many people to regard capitalism as a turbulent milieu in which neither the economic winners nor the losers ever get to enjoy stability.

Phelps sees the role of growth-enhancing entrepreneurship differently. Innovation leads not to “creative destruction,” but to “nondestructive creation,” in which the free and uncoordinated contest of ideas generates growth. Phelps then goes beyond economic formalism to suggest ways in which nondestructive creation can be fostered. This work is still under way, but there are already signs that it will make an enormous contribution to our understanding of business management and innovation, and the ways in which they can (and probably should) be taught. Anyone making choices about business or government policy — for example, about how to invest in innovation — would probably make them differently after an acquaintance with Phelps’s ideas.

Embracing Entrepreneurial Risk
The Nobel Prize was formally awarded to Phelps in 2006 for his “inflation and employment” theory. First published in 1968, that theory refuted the then widely held notion that there is always a trade-off between inflation and unemployment. Instead, Phelps proposed that jobs were affected less by actual inflation than by the perception of inflation to come: more specifically, by employers’ expectations of the demand for their products or services and thus the number of people they would have to hire. This insight — a decoupling of the threat of inflation from the fear of unemployment — gave macroeconomic forecasters, including many central banks, the confidence to use much more effective instruments for managing the economy than they would otherwise have used. And it also neatly anticipated both the “stagflation” of the 1970s and the “inflationless boom” that began in the 1990s and continues today.

At first as an outgrowth of his work on inflation, Phelps (who,  I should acknowledge for disclosure’s sake, is a friend of mine and a fellow faculty member at Columbia University) began to look more closely at other possible causes of prosperity. What, for example, did cause the inflationless boom of the 1990s? And why did it take hold more completely in some countries than in others? This led him in turn to study the “institutions of capitalism,” as he called them, and ultimately to focus, as Schumpeter and Friedrich von Hayek had in the early 20th century, on entrepreneurs: creators of the technological and managerial innovations that lead to productivity and growth. Having shown that inflation per se does not directly drive a prosperous economy, Phelps posited that under the hood of macroeconomic and institutional forces the engine of change is the entrepreneur.

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