Innovation & credit markets

Session 2, April 7 2011

Now this is an exciting topic! Joseph A. Schumpeter (1883-1950) is the key pioneer in the field of economics and innovation. Schumpeter wrote the Theory of Economic Development in 1911, almost 100 years ago! Schumpeter on the credit market: “He can only become an entrepreneur by previously becoming a debtor … what he first wants is credit. The core ethos of capitalism looks constantly ahead and relies on credit in launching new ventures. From the Latin root credo —'I believe'— credit represents a wager on a better future ... In the absence of credit, both consumers and entrepreneurs would suffer endless frustrations”.

Initially, the emergence of innovative entrepreneurs pushes interest rates higher, as demand for credit shifts upward.

[DIAGRAM. Demand for credit increases at each level of the interest rate!]. The result is a higher level of interest rates…

Now, Schumpeter also praised financial innovation — up to a point. In the case of railroads in the second half of the XIXth century, or the automobile industry, he states that “credit creation” in the form of overdrafts and car loans [i.e credit creation on a large scale] made it possible to finance these innovations.

[DIAGRAM. The supply of loanable resources increase]. Note that the net result is a stable interest rate + more credit!!! This is the kind of result you want to have!

But then he adds: “Some of that lending was granted with almost unbelievable freedom and carelessness”. Does that ring a bell? Sounds familiar? BOOM-AND-BUST IS INDEED PART OF THE PACKAGE!!!!. Schumpeter made a distinction between productive & non-productive financial instruments. When bankers create financial instruments to “play amongst themselves”, then the risk of a bubble increases dramatically. But is it possible to really make that distinction? On this topic, see [NOT required reading!] the paper by Charles G. Leathers & J. Patrick Raines: “The Schumpeterian role of financial innovations in the New Economy's business cycle” Cambridge Journal of Economics, 2004, No. 28, Vol. 5, pp. 667-681.
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Innovation vs. invention

An innovation is an invention with a proven track record in the market place! Please remember this point when writing Assignment No. 2!
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