Joseph A. Schumpeter (1883–1950) is one of the most famous economists of the 20th century, mainly because he coined the term ‘creative destruction’ (Schumpeter 1942). However, much more important for economic theory are his analyses of the relationship between the financial system and economic growth. Accordingly, he is considered the ‘patron saint’ (Solow 1994: 45) in this field.
The motivation for our paper (Bofinger et al. 2021) is the discovery that the prevailing literature on the relationship between finance and growth has misinterpreted Schumpeter. The literature portrays Schumpeter as advocating a paradigm that he explicitly rejected. While Schumpeter advocated an approach in which money plays a dominant and independent role (‘monetary analysis’), he is portrayed as advocating a school of thought in which the monetary sphere is merely a reflection of the sphere of goods (‘real analysis’).
The price for this misinterpretation is high. We see it as an explanation for the fact that the literature, after decades of research, has to admit that it has difficulties explaining basic relationships, especially the liquidity creation of banks. Moreover, the literature has so far failed to provide convincing evidence of positive effects of the financial system on growth in advanced economies. Nor has evidence been found for the link between saving and credit growth, which is a central transmission channel of real analysis.
We show that a correct interpretation of Schumpeter helps to overcome the theoretical and empirical challenges faced by the prevailing literature. Due to his monetary approach, the ‘true Schumpeter’ offers a more realistic framework for analysing the finance and growth nexus.
Schumpeter's most important insights into the role of the financial system are based on his critical view of ‘real analysis’, which can be approximated by the loanable funds theory. This theory explains the interest rate in terms of real factors, i.e. the consumption/saving decision and the investment decision. The theory is based on the critical assumption of a general-purpose good that can be used interchangeably as a consumption good, capital, ‘savings’,1 and as an investment good. In this model, saving is the only source of financial funds. Banks are reduced to the role of intermediaries ‘easing financial frictions’ between savers and investors.
The most important insights of Schumpeter's ‘monetary analysis’ are the following:
- Banks can independently create credit and thus money: "The banker is therefore not so much an intermediary of the commodity 'purchasing power' as a producer [italics in original] of this commodity". (Schumpeter 1934: 62)
- Banks play a crucial role in the process of economic development: "The essential function of credit in our sense consist in enabling the entrepreneur to withdraw the producers’ goods which he needs from their previous employments, by exercising demand for them, and thereby to force the economic system into new channels" (Schumpeter 1934: 93).
- Savers are irrelevant to finance (or at least overvalued) because ‘savings’ are not necessary as an input to the financial system: “it is much more realistic to say that banks "create credit", that is that they create deposits in their act of lending, than to say that they lend the deposits entrusted to them. And the reason for insisting on this is that depositors should not be invested with the insignia of a role they do not play. The theory to which economists have clung so tenaciously […] attributes to them an influence on the 'supply of credit' which they do not have. " (Schumpeter 1954: 1080). Schumpeter even goes so far as to call saving the "economic general disruptor" (Schumpeter 1954: 267).
- The ‘monetary analysis’ opens the perspective of financial instability that is missing in the ‘real analysis’, where financing is identical with an increase in the capital stock: "Speculation in the narrower sense will take the hint and [...] stage a boom even before prosperity in business has had time to develop. New borrowing will then no longer be confined to entrepreneurs, and 'deposits' will be created to finance general expansion, each loan tending to induce another loan, each rise in prices another rise." [...] Indeed, the phenomena of this secondary wave may be, and generally are, quantitatively more important than those of the primary wave. [...] the processes of the secondary wave do indeed provide us with a wealth of examples of unproductive credit" (Schumpeter 1939: 150-151).
It is surprising that in the literature on the finance and growth nexus, especially in the publications by Robert King, Ross Levine, and Thorsten Beck (e.g. King and Levine 1993a, Levine 2005, 2021, Beck et al. 2000), explicit reference is made to Schumpeter as a theoretical pioneer without addressing his fundamental distinction between ‘real analysis’ and ‘monetary analysis’. Instead, the authors present him as a proponent of the loanable funds theory, in which banks merely act as intermediaries between savers and investors. For example, in Levine (2021: 13) the above quote (Schumpeter 1934: 62) is reproduced omitting the key passage "in the commodity 'purchasing power' as the producer of this commodity":
“In 1912, Joseph Schumpeter argued: ‘[T]he banker is therefore not much primarily a middleman ... He authorizes people in the name of society ... to [innovate]. (Schumpeter 1912, p. 74)2 Schumpeter was stressing that one of the key functions of the financial system is to decide which firms and individuals get to use society's savings."
In this sense, King and Levine (1993a: 717) also state:
"In 1911, Joseph Schumpeter argued that the services provided by financial intermediaries - mobilising savings, evaluating projects, managing risk, monitoring managers and facilitating transactions - are essential for technological innovation and economic development. "
In the so-called ’Schumpeterian growth theory’ (e.g. Aghion and Howitt 1990, Aghion et al. 2015), no room is left for the banker, which Schumpeter regarded as the decisive actor in the innovation process.
In our view, the misinterpretation of Schumpeter had negative consequences for research on the finance and growth nexus:
- After decades of research, Levine (2021: 8) admits that "the literature does not yet provide a definitive answer to the questions: Does finance cause growth, and if so, how?".
- There are serious problems in the literature with the concept of ‘liquidity creation’, which, according to Levine (2021: 36), "is one of the most important services that banks provide to the economy." Beck et al. (2021: 1) note that there is "little research focusing specifically on whether and how liquidity creation, as a key function of banks to foster long-term investments, contributes to growth".
- It has led the research to an interpretation of ‘financial development’ as a static concept, in contrast not only to Schumpeter (1934) but also to Goldsmith (1969), who is considered another pioneer in this field. Thus, empirical papers try to explain the growth effects of the financial system with static variables, above all the level of private debt relative to GDP. While positive effects could be found for large panels dominated by developing countries, this is not the case for advanced economies with larger and more developed financial systems.
- Recent empirical analyses even show a negative growth effect above a certain debt threshold. Levine (2021: 29) notes that "researchers have not explained what causes these nonlinearities".
- Finally, there is also no evidence for the crucial role that the literature attributes to the financial system in ‘mobilising savings’ and for positive effects of ‘savings’ on growth.
In our view, the problems in the literature are related to the use of ‘real analysis’, i.e. the loanable funds theory as a theoretical framework.
- At a general level, it is not surprising that a model in which the financial sphere is identical to the real sphere is unable to understand how finance causes growth in the modern financial system, where the financial system is often completely detached from the real sector.
- How can a model in which the role of banks is reduced to the intermediation of a general-purpose good understand the process of liquidity creation in reality? The only approach is the complex model of Diamond and Dybvig (1983), which is based on "unrealistic critical assumptions" (Rodrik 2017). Papers by the Bundesbank (2017) and Bank of England researchers (McLeay et al. 2014) shows that in a monetary framework, the mechanics of liquidity creation are relatively simple.
- Understanding the role of bankers as ‘purchasing power producers’ implies that financial development is a dynamic concept, so that its impact on growth must be analysed with the growth rates of financial aggregates. Even the recent work by Beck et al. (2021) identifies 'liquidity creation' with a static balance sheet concept.
- Since the loanable funds model assumes that financing always involves an increase in the capital stock, it is unable to deal with "unproductive credit" (Schumpeter 1939), which finances consumption or the speculative purchase of existing assets (real estate, companies).
- For monetary analysis, the lack of a link between ‘savings’ and the financial system is not a challenge but a confirmation that finance is not based on ‘savings’.
In the empirical part of our work, we analyse the effects of the financial system on the basis of Schumpeter's hypotheses that:
- credit growth has a positive impact on GDP growth;
- credit growth is independent of saving growth; and
- saving growth has no impact on GDP growth.
Using credit data from the Bank for International Settlements (BIS) database, we test Schumpeter’s hypotheses. The importance of using dynamic indicators to analyse the impact of finance on growth, as suggested by Schumpeter and Goldsmith, becomes already clear by plotting the data for GDP growth and the widely used finance indicator ‘bank credit to GDP’ versus ‘bank credit growth’.
Using panel estimations with various specifications, we find a strong positive relationship between credit growth and GDP growth in both developed and developing countries (Figure 1). For developed countries, however, the growth effect is only significant in the period before 2000. We cannot find positive effects of saving on either GDP growth or credit growth.
Source: BIS; Bofinger et al. (2021).
To test for causality between credit growth and GDP growth, we then use a structural vector autoregressive (VAR) model for the US. The impulse response functions suggest a positive effect of a credit supply shock on GDP growth, while we find negative and non-significant growth effects for a savings shock. Finally, we conduct Granger causality tests for 43 countries to analyse the interaction between GDP growth and credit growth. The data show that Granger-causality runs in both directions, consistent with Schumpeter's ‘second wave’ approach. As a robustness check, we use forecast error variance decompositions (FEVD), which support our Granger test results. Countries where there is Granger causality from credit to GDP also show a strong contribution of credit shocks to GDP.
Robert Solow (1994: 45) made a remarkable statement: "Schumpeter is a kind of patron saint in this field. Perhaps I am the only one who thinks he should be treated like a patron saint: paraded one day a year and more or less ignored the rest of the time." Our contribution shows that Schumpeter, although ritually paraded in the literature, has in fact been de facto ignored or, worse, misinterpreted. The finance and growth literature is dominated by the loanable funds theory or ‘real analysis’, which is in direct contrast to the ‘monetary analysis’ that Schumpeter propagated. This misinterpretation is not only a problem for the history of economic thought; it has also led theoretical and empirical research down the wrong track. Nothing reflects this more than the inability to explain the process of ‘liquidity creation’ simply and realistically. The lack of empirical evidence for the main transmission channels of the literature and the evidence for the hypotheses of the ‘true’ Schumpeter have implications that go beyond the finance–growth nexus. They call into question the entire macroeconomic literature on finance (e.g. Mian et al. 2021a, 2021b), which is still based on the paradigm of real analysis, where the monetary sphere is nothing but a disguised real sphere.
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1 Many authors use the term ‘savings’ as a synonym for ‘saving’. This is problematic as ‘savings’, in contrast to saving, is a term that is not used in official national account or financial account statistics. In addition, while saving is a flow concept, ‘savings’ creates the impression of a stock concept which must lead to confusion.
2 Schumpeter (1911) is the original German version of the English version (Schumpeter 1934).