Schumpeter’s virus: How “creative destruction” could save the coronavirus economy

You don’t have to be an economist to see that Covid-19 has stopped much of the economy in its tracks, or to wonder how and when it will bounce back. But there is also the question of what, once the economy settles into its new normal, that new normal will look like.

When economists think about this sort of question, they start with the concept of “potential growth”—that is, how quickly the economy is capable of growing without inflation or other worries, if all goes well and things live up to their potential. This concept is foremost in the minds of central bankers when they ponder for how long liquidity injections can continue without creating inflationary pressures. It is central to the thinking of Treasury officials when they ask how much additional public debt is sustainable. It is crucial, above all, for understanding how living standards will develop not just now but in the future.

The crisis will influence potential growth through four channels, three negative and one positive. On the negative side, it will interrupt schooling, depress public investment, and destroy global supply chains. Positively, by disrupting existing industries and activities it will open up space for innovative new entrants, through the process that the early 20th-century Austrian economist and social theorist Joseph Schumpeter referred to as “creative destruction.”

Where those multiple negatives are immutable and immediate—they are baked in, as it were—how powerfully the positive channel will operate remains uncertain for the moment. The answer, which will become apparent only over time, hinges on policy choices we make now.

Schools and hard knocks

The most important negative is the adverse impact of the crisis on schooling. Students who experience interruptions to their education generally do not make up that lost learning later. Not being in school early in life impairs cognitive development in ways that cannot be undone by spending more time in the classroom later. We know this from studies of pre-school programmes, which show that children enrolled in such initiatives, specifically those emphasising language, pre-literacy and mathematics, show superior cognitive development. We know it from studies of earlier pandemics, such as the 1916 polio outbreak in the United States, when schools shut down and students never made up their lost education. As adults, the affected individuals are less productive; this is evident in the fact that their earnings are below those of otherwise comparable individuals who did not suffer such interruptions.

It is tempting to speculate that this time will be different because of distance learning.  But anyone with firsthand experience, whether a teacher or a student, will tell you that Zoom is a very imperfect substitute for the classroom. Students are more easily distracted. The visual cues on which teachers rely are harder to discern. Feedback is more limited, evaluation more difficult.  With time, schools and instructors may learn how to improve online education. But this won’t compensate the students of 2020 for what they have lost.

A second negative will be less government spending on infrastructure, education, and research and development. Governments will come out of the crisis much more heavily indebted. There will be a reluctance to add further to those debts, even if financial markets stand ready to finance them for the moment. Already we see evidence of stimulus fatigue and hear warnings of an impending debt apocalypse. Britons will recall the hard-right turn to austerity by the Conservative-Liberal Democrat coalition following the global financial crisis and the fiscal stimulus put in place in 2009. Regrettable perhaps, but no less predictable for the fact.

Almost inevitably, politicians will soon enough again look for something to cut. That something won’t be social programmes, given how the crisis has bequeathed new arguments for public support for healthcare, income maintenance (even a universal basic income), and housing the homeless. Nor will it be defence spending, since, like it or not, the west has embarked on a new Cold War with China.

What remain are further cuts in the kinds of public investments that shape the economy’s capacity to grow. This means less basic research of the sort that only government can fund. It means less modernisation of the transportation and communications networks on which business enterprises depend. It means less finance for education, adding a further insult to the immediate injury to human capital I have already described. It means less public support for re-training, the worst possible thing under current circumstances. It means less investment in climate change abatement, notwithstanding wistful talk that the virus has reminded society of its dependence on nature and people of the pleasures of a less energy-intensive life.

We saw this—both the devastating cuts to public investment and their negative impact on growth—in the Greek crisis, when Athens, struggling to stabilise a crushing debt, drastically curtailed public spending. We saw it in the UK, too, when George Osborne ended up reducing the deficit largely by implementing swingeing cuts in public investment. After various faltering and half-hearted efforts to reverse this, Rishi Sunak finally sought to end this growth-impairing investment drought decisively in his first budget in early March. Unfortunate timing, that.

The third negative is the impact of the crisis on international trade and global supply chains. We have come to understand very well that the offshoring and outsourcing of production is not an unmitigated blessing. It is not a blessing for the workers who see their jobs migrate to foreign countries. In addition, it leaves our economies less resilient and more vulnerable to supply-chain disruptions. This was illustrated by the Fukushima earthquake, which interrupted Japanese supplies of auto parts to the motor vehicle industry, and—more on point—now by the outbreak of coronavirus, which interrupted the flow of pharmaceuticals and personal protective equipment from China.

With all that said, there is no question that global supply chains and just-in-time inventory control allowed firms to cut costs, grow their markets and produce more for less. This will now change. Firms will be more reluctant to source parts and components from faraway places, and politicians will be more reluctant to let them. Just-in-time economics will give way to just-in-case economics, as the economist Willem Buiter has put it. In the US, on Capitol Hill proposals are already being drafted for taxes and rules to encourage American companies to repatriate key operations from China. These measures will have consequences. Costs will be higher; such is the price of security. Efficiency improvements that translate into economic growth will accrue more slowly. Potential output growth will be correspondingly less.

Out with the old

That the news is bad is no surprise. But there is a silver lining, namely the impetus that the Covid-19 provides to creative destruction. The disappearance of old firms and even entire industries, as Schumpeter argued in his magnum opus, Capitalism, Socialism and Democracy, published in the immediate aftermath of the Great Depression, creates space for new, innovative successors to fill the void. The virus is certainly doing a fine job in advancing the destruction part of the Schumpeterian equation. The question is what we will create to replace what is being destroyed, and how quickly and intelligently we will create it.

No doubt there will be more impetus for the application of artificial intelligence, robotics and other new technologies to sectors and activities where close contact is problematic. Just as Amazon is training AI-powered robots to pick and pack orders in its warehouses, many others who process and distribute goods, and perhaps especially those such as meatpackers in sectors where infection may be a special concern, will surely now be jolted to move fast in the same direction.

Consequential changes will not be limited to the factory floor. In the months since the virus was detected, finance, retail and certain health services have all substantially moved online. While these behavioural changes are an immediate response to the virus, many of them will be permanent. That is predictable because in many cases the role of Covid-19 has not been to bring forward improvised fixes from out of the blue, but rather to give economic history a nudge in the direction in which it was already going.

Take online shopping virgins, who—during the lockdown—have lost their digital innocence. They may not entirely abandon the corner store, but neither will they abandon their computer screens after the habit has been acquired. Now that doctors and nurses have learned what kind of symptoms can be diagnosed over Skype, and now that medical insurance companies that previously resisted doing so are reimbursing physicians for tele-diagnostics, there will be a permanent reduction in the frequency of GP visits and house calls.

These changes will not be to everyone’s liking. They will not be universal: not all visits to doctors’ offices will disappear. But these new practices will enable medics to diagnose and treat more patients at lower cost to society and, in the British context, the NHS. Properly measured, they will constitute an increase in productivity and a contribution to economic growth.

Counterintuitive as it seems, we regularly see productivity accelerate in the wake of major dislocations—when crises produce gales of creative destruction. The 1930s, when the United States experienced the Great Depression, was also the decade in which it recorded the fastest productivity growth of any decade in the 20th century, as old sectors, such as the railways, shed redundant workers and dynamic new industries, commercial trucking for example, ramped up employment and output. It is no coincidence, in other words, that Schumpeter came up with his idea when he did. It may seem almost indecent to find merit in a period when millions languished in unemployment. But if ever there was a time for a glimmer of hope, that time—when millions are again languishing in unemployment—is now.

This potential for creative destruction creates a sharp dilemma for policy makers, however. In many advanced economies, public policy has sought to keep firms alive through the spring and summer in the hope that they will somehow be able to resume business as usual in the autumn. It has aimed at maintaining existing connections between workers and employers. European governments are subsidising wages to enable firms to keep their employees on payroll. The British government plans on maintaining its furlough scheme, under which it pays 80 per cent of staff wages up to £2,500 a month, at least until October (albeit with employers likely to have to start chipping in something from August).

There are compelling arguments for this approach. It keeps viable businesses intact. It preserves good matches between employers and employees—matches that took time, sometimes years, to establish. Preserving those matches is the quickest way of getting people back to work—assuming that the firms in question survive.

But preserving existing matches accomplishes nothing if those matches are rendered worthless by the pandemic. Workers are going to have to move out of hospitality, travel and retail, since those sectors are unlikely to recover fully for the foreseeable future, if ever. Many firms in those sectors are eventually going to have to close down, whatever policies governments pursue today. Fewer people will be taking business trips, cruises, and shopping excursions to the high street and the shopping centre. For the moment, those activities are unsafe. Even once they are again safe (whenever that is), habits will have changed. Business trips won’t disappear, but they will be fewer now that companies and workers have discovered Zoom and Microsoft Teams.

We therefore want the mix of jobs to change: we want, for example, hotel receptionists to retrain as healthcare workers. But the more generously governments pay hotel chains to keep their employees on payroll, the less will be the incentive for those receptionists to go back to school. And the less immediate need (or reward for) doing that retraining there is, the longer the process will take to complete.

Back when we imagined that the coronavirus crisis would be short and the recovery would be V-shaped—in the different world of a couple of months ago—it made sense to protect jobs. Now that we understand better that many of the changes wrought by the crisis are permanent and that more than a few of those jobs will—and should—disappear, it makes more sense to protect the worker. This means providing him or her with unemployment benefits, monthly stipends, and tuition subsidies. It means using the public sector’s financial resources to ramp up training for new workers in healthcare, homecare, and other expanding sectors while resisting predictable calls for austerity.

There are good reasons, from simple compassion to the inefficiency of bankruptcy and insolvency proceedings, to support owners and employers by, among other things, extending some payroll subsidies to them. It is neither socially desirable nor economically efficient for each and every pub and Indian restaurant in the British Isles to disappear as a result of the social and behavioural changes wrought by Covid-19. Only some of them.