Economic Theory

When Samuelson arrived at Harvard, the star of its economics department was Joseph Schumpeter, a flamboyant Austrian economist recently recruited from the University of Bonn. He had arrived at Harvard, full time, in 1932, the result of a long attempt to recruit him.

Though Schumpeter came from a German-speaking community that considered itself Austrian, he was viewed as an Easterner; he never felt he completely belonged. Coming to maturity in an aristocratic family in Vienna during the last years of the Hapsburg Empire, he lived through the cultural flowering of those years. In 1901, he entered the University of Vienna, graduating in 1906 in law, though he had discovered his inter­est and aptitude for economics, and having published three articles on statistics and one on the mathematical method in economics. His most important teacher was Eugen von Bohm-Bawerk, and Schumpeter was immersed in the controversies between the marginalism of his teachers, the German historical school of Berlin's Gustav Schmoller, and Marxism. His fellow students, who included Ludwig von Mises, Otto Bauer, Rudolf

Hilferding, and Emil Lederer, spanned the political spectrum from liberal­ism to Marxism.^a

Not sure of how he could develop his career, and having expensive tastes that could not be satisfied on a regular academic salary, Schumpeter toured western Europe, visiting Britain. He loved the idea of becoming an English gentleman, visiting “good English clubs,” and he famously claimed to have had an audience with Alfred Marshall at his home.

In this book, Schumpeter sought to reconcile the different continental schools of economics, much as Marshall had reconciled competing approaches to economics in Britain. If he could do this, he could bring to an end to what was termed the Methodenstreit, the battle over methods that divided German­speaking economics in the closing decades of the nineteenth century, after Austrian Carl Menger had published a critique of the historical school headed by Gustav Schmoller, in Berlin. Schumpeter argued that theory could provide a way to bridge the claims of different schools. Though Schumpeter clearly sided with Menger in attaching great importance to static theory and the subjective theory of value, he decisively rejected Menger's claim that the theory analyzed the “essence” of economic phenomena. It was no more than a device for organizing ideas that were to be tested against historical reality; in this sense, he was adopting an instrumentalist methodology. This fits with what Leontief describes as Schumpeter's “masterly exposition of the ‘method of variation'—later popularized under the name of ‘comparative statics.'”^[10] The importance of comparative statics was to become central to Samuelson's main work in economic theory.^b

On the basis of this book, Schumpeter obtained a position at the University of Czernowitz, in the far east of the Austrian Empire, in what is now Ukraine.^c There his wrote his Theory of Economic Development (1934[1911]).^[11] From Czernowitz he moved to the University of Graz, once his hometown, becoming the youngest professor of economics in the Austrian Empire.

Schumpeter spent the First World War teaching in Graz, and while there he became involved in politics. He tried but failed to enter government dur­ing the war, but in 1919, his university friend, Otto Bauer, became foreign minister and on Hilferding's advice, Schumpeter was appointed finance min­ister. He was a top minister in a socialist government despite being “a con­servative who had no party affiliation and no independent power base.”^[12] His proposals for reconstructing the Austrian economy on the basis of opening up trade and importing capital came to nothing, and in office at the time of the Treaty of Versailles, he never forgot the effect of the Allied demands for reparations.

His tenure at the finance ministry did not last long; neither did a career as a private banker, which ended with the failure of the bank after which he was saddled with large debts. However, in 1925 he returned to scholar­ship, as he put it, after obtaining a position as Professor of Public Finance at the University of Bonn, for which he was supported by Gustav Stolper, the leading economic journalist in Vienna. Schumpeter was, Stolper argued, eminently well qualified for the position, but was being held back by his flamboyant, “un-Austrian,” “un-Bourgeois” lifestyle, the attempt to support which was the reason for his unsuccessful venture into banking.^[13] Success, however, turned to tragedy in 1926. Shortly after the death of the mother to whom he was devoted, Annie Reisinger—with whom Schumpeter had fallen in love and married, despite his family's disapproval of her low social status and the fact that the status of a previous marriage of his was not clear—died in childbirth, as did his prematurely born son.

His connection with Harvard came shortly afterward. Taussig, his friend since 1913, persuaded him to become a visiting professor, and for five years he divided his time between Harvard and Bonn. When a suitable vacancy arose in 1928, Taussig, Burbank, and even Harvard's President Lowell tried to persuade Schumpeter to come permanently, and he eventually came in 1932. Recruiting him was a major coup for Harvard. This was the teacher who would provide Samuelson's first taste of economic theory at Harvard—a showman and brilliant economist, but stricken with personal insecurities that led him to follow a work schedule that threatened his health. Additionally, he had a desire for popularity that resulted in his going further than most professors in making himself available to students and in displaying a notori­ous liberality in grading. He lived with Taussig until, in 1936, he married an economic historian and specialist on Japan, Elizabeth Boody, who looked after him until his death in 1950.

Giving up an earlier attempt to write the book on money that had occu­pied him for several years, Schumpeter devoted himself to writing the book that was published in two volumes as Business Cycles (1939). Produced single­handedly, this compendium of economic history and statistical analysis sought to provide a comprehensive account of economic fluctuations. It was, however, eclipsed by the appearance of Keynes's General Theory (1936). It was Keynes's theoretical apparatus—oversimplified in the view of Schumpeter and his senior colleagues—that the graduate students wanted to discuss. They were not interested in the mixture of theory, statistics, and economic history in his book. Success came not with this book but with two others: Capitalism, Socialism and Democracy (1942), written much more quickly than the book on business cycles, and which he considered a potboiler; and A History of Economic Analysis (1954), unfinished at his death but brought to publication by his devoted Elizabeth Boody, assisted by several of his colleagues.

Samuelson's first encounter with Schumpeter had been on December 26, 1934, when Schumpeter had contributed to a session on the business cycle at a meeting of the American Statistical Association being held in Chicago.^8,d On coming to Harvard, Samuelson's first encounter with Schumpeter was in Ec. 11, the main economic theory course for graduate students. Schumpeter was assisted by Paul Sweezy, who was to become one of America's most prominent Marxist economists.^[14] This course was legendary not just because Taussig had taught it for so long but also because of the Socratic method he had perfected. It had been the model for Viner's course that Samuelson had taken at Chicago, and Taussig's method was admired and copied by other teachers at Harvard who had at one time been through it.⁹

Taussig would ask a question, choosing a student who could be relied upon to give a suitably stupid answer, which would then be discussed by the entire class without the student's being told whether he or she (the class included women from Radcliffe) had given the correct answer. It was, Samuelson believed, not an effective method for teaching modern economic theory, but it was favored by Taussig because, as he once conceded to Samuelson over dinner, he had not kept up with developments in economic theory since the First World War, focusing instead on his specialism of international trade. Schumpeter was less effective than Taussig in teaching this way, but he held the students attention in other ways.

Whereas Taussig was “a rather austere gentleman of the old school,” Schumpeter played the showman.

After, and not before, the students had assembled for the class hour, in would walk Schumpeter, remove hat, gloves, and topcoat with sweep­ing gestures, and begin the day's business. Clothes were important to him: he wore a variety of well-tailored tweeds with carefully matched shirt, tie, hose, and handkerchief. My wife [Marion] used to keep track in that period of the cyclic reappearance of the seemingly infi­nite number of combinations in his wardrobe: the cycle was not simple and it was far from random.¹⁰

Another student, Robert Triffin, remembers Schumpeter talking about the mysteries of bilateral monopoly that had kept him awake the previ­ous night while “playing with his gloves or his wallet.”¹¹ He would lay out a problem and leave the class to argue among themselves, after which, “with a discrete yawn, he expressed amazement at how enthusiastic the combatants were, associating himself with the others' lack of interest in a problem so dry and uninteresting.”¹² Some students would follow up the readings he posted on the blackboard, but he would turn the discus­sion around to other subjects.

Samuelson praised the contents of the course for the range of both authors they were expected to read and the topics: “It involved readings in Marshall, Wicksell, Pigou, Bohm-Bawerk, Knight, and Wicksteed. In addition, much was made of Chamberlin, Robinson, and current journal articles by Hicks, Harrod, Sraffa, and others. Such advanced authors as Cournot, Edgeworth, and Hotelling were at least sampled.”¹⁴ Even though Chamberlin also dis­cussed the subject in a separate course, Schumpeter covered the controversy over the theory of value that erupted in the 1920s and its outcome, the the­ory of monopolistic competition. Samuelson remembered the order of topics being the firm, the industry, monopolistic competition, general equilibrium, and the marginal productivity theory of income distribution, which covered the theory of capital. Welfare economics was scheduled, but Schumpeter did not manage to cover it. Samuelson’s memory of the topics covered in Ec. ιι fits with the evidence from notes that another student, Wolfgang Stolper (son of the journalist Gustav Stolper, with whom Schumpeter had been associ­ated), had made the previous year, when Schumpeter had shared the course with Taussig.¹⁵

Perhaps because Taussig had focused more on the nineteenth-century classics—Ricardo, Mill, and Marshall—Schumpeter began his part of the course with Marshall’s demand curve, pointing out the different ways it could be derived: from a utility curve, from indifference curves, or as a sta­tistical relationship. Stolper’s notes suggest that there was an emphasis on diagrammatic treatments of theory, with the occasional equation but few if any algebraic proofs. Schumpeter spent much time on costs, covering both marginal productivity and income distribution and the literature arising out of the so-called cost controversy, comprising many articles from the Economic Journal, including the theory of imperfect competition, monopoly, and bilat­eral monopoly. The reading list included The Theory of Wages, The Economics of Imperfect Competition, and The Theory of Monopolistic Competition.¹⁶ The syllabus covered material that would have been familiar to almost anyone trained in economics in the half century after the Second World War.

For some students, the course appeared very mathematical. Triffin, coming from a training in law, noted Schumpeter’s “constant use of mathematics” and though he admired it, he was dumbfounded and convinced he was watching something in which he would never be able to participate.¹⁷ More percep­tively, Abram Bergson observed that Schumpeter, though he used mathemat­ics, never appeared at home with it in the sense that he was not able to use it to generate new results. “I had,” he said, “the impression that he was inspired by his conviction that this is the way economics would become a science—by the increased use of mathematics—and that he must be a champion for it.”¹⁸ As a result Bergson found the course less useful and much less interesting than Leontief's. For Triffin, on the other hand, the course was important: it was his fascination with Schumpeter that persuaded him to stay at Harvard much longer than he had intended. Samuelson believed that Schumpeter was at his best in the classroom where he was not constrained by a script, as he was on formal occasions such as his Presidential Address to the American Economic Association. He told many stories, of which he had an immense number, and never repeated them.

When he taught Samuelson, Schumpeter was actively working on his mag­num opus, Business Cycles. He was an enthusiast for mathematical economics, but as the book's subtitle made clear, it was an attempt to integrate theory, history, and statistics. Not even the theory was formulated mathematically. He talked in terms of a “model,” but this was far from a mathematical model as the term was coming to be understood (a set of equations that determined the values of variables of interest) and was defined very loosely. The task of the economic theorist was not to derive explanatory hypotheses or theorems that could verified. It was primarily to derive concepts or analytical tools. Concepts might embody nothing more than methods by which they could be defined and measured, a definition reminiscent of Bridgman's operational- ism. A “model” or “schema” was, for Schumpeter, a set of concepts or analyti­cal tools framed to deal with a particular problem: “A set of such analytic tools, if framed to deal with phenomena which form a distinct process, we call a model or a schema of this process.”¹⁹

This was the methodological basis for his work on business cycles. He analyzed the economic process through what he considered a complex inter­action of theory and statistical and historical analysis. The conditions neces­sary for induction to be a valid method of reasoning were not satisfied, for a particular time series could always be explained in different ways, with the result that statistical data alone could never verify a theory. “There is,” Schumpeter wrote, “along with Nonsense Induction, such a thing as Spurious Verification.”²⁰

[N]o statistical finding can ever either prove or disprove a proposi­tion which we have reason to believe by virtue of simpler and more fundamental facts. It cannot prove such a proposition, because one and the same behavior of a time series can analytically be accounted for in an indefinite number of ways. It cannot disprove the proposi­tion, because a very real relation may be so overlaid by other influences acting on the statistical material under study as to become entirely lost in the numerical picture, without thereby losing its importance for our understanding of the case.... Material exposed to so many disturbances as ours is, does not fulfill the logical requirements of the process of induction.²¹

He made it clear that this was the commonly accepted opinion among stu­dents of business cycle theory.

Despite his reputation for not pushing his own work and being willing to treat fairly those who did not agree with him, these methodological points are ones that he would have made in the course he co-taught with Haberler, and which Samuelson took in his second year.²² Schumpeter would also have made the point found at the start of his book—namely, that to analyze the business cycle was to analyze the working of a capitalist economy. Cycles were, he claimed, the essence of the economic system as much as the beat of the heart was of a biological organism.²³ The analytical apparatus to which he turned was very similar to the one he had used almost thirty years earlier, in his Theory of Economic Development. This involved consideration of a normal business situation that could be analyzed in terms of general, or Walrasian equilibrium, disturbed by innovations and other events. The economy had to be analyzed at the level of the individual company or household, for though it was possible to talk about equilibrium at the level of aggregates—as was done in much business cycle theory—he considered such reasoning superfi­cial. Analysis in terms of aggregates took no account of the industrial pro­cesses operating beneath the aggregates, and it was these processes that really mattered. In his book, Schumpeter's remarks were the prelude to a largely historical and statistical account of the cycle.

Schumpeter's Business Cycles was published in 1939. The methodology and the theoretical framework on which the book was based will have been familiar from his teaching, but even his students may have had to wait until its publication to see its full scale. Given that he was beginning to focus on business cycle theory, it seems virtually certain that Samuelson was one of the students who attended an evening seminar at which he talked about his book. As the evening progressed, it became clear that hardly anyone had read the book, and most of the discussion was about Keynes. Some of the students present said that it was the only occasion on which they had seen him genuinely furious; suffering from acute embarrassment, they afterwards wrote a letter of apology.²⁴ However, though the students may have realized that they should have been as willing to take Schumpeter's work as seriously as he took the views of those with whom he disagreed, they will have become aware during the year that some of the established economists who had read it were critical of it.