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2 June, 2012  ▪  Yuriy Bazhal

Reforms According to Schumpeter

A landmark work by the world-renowned economist confirms that the current “reforms” of the Ukrainian government will inevitably lead to an economic crisis

Joseph Schumpeter’s work The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle has recently been published in Ukrainian. The book has Ukrainian roots – the author wrote most of it while teaching at Chernivtsi University in 1909-1911. Although this fundamental work is a century old, it would be hard to find a more topical treatise on economic theory for contemporary Ukraine. What passes for “reforms” in our country is, in fact, the “patching of holes”. Schumpeter argues that if preserved, this state, which he calls “traditional circular flow”, inevitably leads to a financial-economic crisis, because true progress cannot be based on the foundation of the status quo that is being maintained. According to Schumpeter, an economy that is based on the recreation and advance of the traditional production structure is incapable of significantly increasing public welfare, because over time, the development of traditional competitive markets slows down the emergence of new added value. Schumpeter substantiated the conclusion that the sustained growth of national income can only be ensured through innovative development. This theory explains the “trap” in which Ukraine’s economy has found itself. Increasing the output volumes of traditional industries, albeit through higher productivity, does not offer a powerful resource for the country’s dynamic development. To illustrate these processes, Schumpeter uses a familiar analogy: “Add successively as many mail coaches as you please, you will never get a railway thereby”. Developing this simile, it can be said that the Ukrainian government is largely adding mail coaches instead of building a new “railway”.

Joseph Schumpeter's book Capitalism, Socialism and Democracy

Schumpeter’s fundamental contribution to the market economy theory is his argument for the decisive role of the innovating entrepreneur in implementing economic development mechanisms. This production factor gives a market economy a significant advantage over the centralised administrative model of management, under which state managers distribute, re-distribute and even increase existing resources, generally within the limits of an established economic circular flow. According to Schumpeter’s theory, this cannot secure long-term national economic development – only that of individual citizens at the expense of others becoming poorer. In contrast, a stratum of innovative entrepreneurs guarantees the economic development of the state. This aspect of the theory is of paramount importance to Ukraine, because we tend to view entrepreneurs in the context of resolving employment issues – the creation of (any) jobs and the formation of a “middle class”, however the latter purpose is not being realized. A prosperous “middle class” emerges (i.e., increase in national prosperity) when there is an efficiently working stratum of innovative entrepreneurs. These are few and far between in Ukraine, for numerous reasons. A good illustration of this are the famous “Oriental bazaars” – employment is ensured and the scale is impressive, but the countries remain poor, since other conditions remain the same.

In Ukraine’s economy, the bulk of financial resources available for supporting innovation are concentrated in large enterprises. This state of affairs is considered to be normal, because the prevalent opinion is that large corporations are technologically more efficient than small companies owing to greater resource potential. But when developed countries formulate their innovation policies, they proceed from the assumption that small and medium enterprises play an important role in the process. They create the “nourishing broth” of technological and economic inventions in competitive markets, and new innovative companies emerge that determine the courses and prospects for a structural transformation of the economy.

Joseph Schumpeter’s work The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle in Ukrainian

Global experience shows that large companies that have grown from small innovative enterprises have the most significant economic effect on securing sustained development. So it is crucial for the innovations policy to establish conditions that would foster small innovative companies and enable their value to grow. Thus, a top-priority task for Ukraine’s state policy on innovation is to provide effective institutional support for the development of small and medium businesses in science-intensive industries. Unfortunately, analysis shows that small business in Ukraine has almost no innovative orientation.

Schumpeter’s work offers an answer to the traditional “killer” question raised by politicians and most experts regarding the innovation-based model of economic development: Where can a poor country get money for this kind of development? The usual answer, at least in Ukraine, is that it is first necessary to advance from the existing production structure, accumulate funds, then channel them into investments for the implementation of know-how. Practice has so far proven this reasoning wrong – innovative funds are not being accumulated and the process is losing momentum. Schumpeter’s conclusion is that innovations are self-financing through the creation of new purchasing power.


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