What is creative destruction? Definition and examples

Creative destruction or Schumpeter’s gale refers to the process in which new entities in the economy replace obsolete ones. The term refers to capitalism’s ability to innovate, destroy, and then reinvent itself. In nature, winter kills off weak life forms, thus making space for new ones to take their place in spring. Innovation, in our economy, creates the new ‘life forms’ which displace the outdated ones.

In other words, old firms and industries, which are not profitable anymore, close down. Their destruction enables the resources to move into more productive processes. The term ‘resources’ in this context refers to capital and labor.

Creative destruction and productivity growth

Ricardo Caballero writes that creative destruction, over the long-term, represents more than half of productivity growth. Ricardo Caballero is a Chilean macroeconomist who holds the Ford International Chair of Economics at MIT. MIT stands for Massachusetts Institute of Technology.

Productivity refers to how much each unit of input produces. Productivity may refer to, for example, how much each worker produces per hour.

Investor Words says the following regarding creative destruction:

The act of a newly created thing destroying its predecessors. This is a common occurrence in industries that thrive on innovation to keep their businesses successful.

“For example, the music industry has watched sales of CDs drop to record lows as a result of more consumers downloading music for free or through services such as iTunes.”

Creative Destruction
Creative destruction is an essential process in a thriving capitalist economy.

Joseph Schumpeter – creative destruction

Joseph Alois Schumpeter (1883-1950), an Austrian political economist, coined the term ‘creative destruction.’

Schumpeter was Finance Minister of Austria in 1919. In 1932, he became a Harvard University professor. He was one of the most influential economists of the last century.

Schumpeter considered ‘creative destruction’ the essential fact about capitalism. He popularized the term as a theory of economic innovation and also the business cycle.

British economist Christopher Freeman, who devoted much time researching the works of Schumpeter, once said:

“The central point of his whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and ‘creative destruction’.”

Schumpeter – Austrian Economics

Schumpeter was what economists today call an Austrian economist. Austrian economics is a school of thought that promotes laissez-faire and liberalism.

Austrian economists believe that the market can find its own path without government intervention.

The 2007/8 Global Financial Crisis

In 2007/8, the Global Financial Crisis occurred. Hundreds of banks across the world would have gone bankrupt if governments had not bailed them out.

Supporters of creative destruction urged governments to let those banks die. If they let them die, then, new ones would take their place.

However, world leaders used hundreds of billions of dollars to bail out banks. They used taxpayers’ money.

Within a few years, many banks were paying their top executives giant bonuses again. Even in banks that were still losing money and owed the taxpayer billions, ‘fat cat’ bonuses were back in operation.

Royal Bank of Scotland

In 2013, the Royal Bank of Scotland posted a pre-tax loss of £8.243 billion ($10.65 billion). However, it paid £576 million ($745 million) in bonuses for its executives.

JP Morgan

In the same year, JP Morgan, America’s largest bank said it would cut its workforce by 8,000 because it had to save money. It also awarded its CEO a 74% pay rise.

Barclays

In 2014, British financial multinational Barclays said it would fire up to 10,000 workers. It also raised its bonus pool from £2.17 billion to £2.38 billion.

Supporters of free-market economics said that the bailed-out banks had not learned their lesson. They had learned nothing because creative destruction did not apply to them.