December, 2021

Israel Kirzner and the "European Miracle"

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Professor Israel M. Kirzner, more than any other economist of the Austrian School (and among economists in general) since the second half of the 20th century, has revived our understanding of the systematic role of the entrepreneur as the driving force of the market as a process of discovery, error correction, and learning (Kirzner 1973). The economist’s task, according to Kirzner (1963 [2011], p. 10), in “explaining what has happened in the real world, or in predicting the likely consequences in the real world of a particular event, the economist thus combines theory with empirical fact.” Thus, economic theory itself is not reality; rather, it is a tool for understanding reality. Its importance rests not only on the internal validity of its propositions, but also, more importantly, on the soundness and applicability of its propositions to understanding the manner in which economic history has unfolded.

Indeed, Professor Kirzner’s work has been recognized and applied not only in economic theory but also in the study of entrepreneurship, business economics, and economic management, for which he was awarded The International Award for Entrepreneurship and Small Business Research in 2006. True to his own understanding of his work, Kirzner was puzzled at being so honored, given his scholarship explains that the source of economic development can be found in the entrepreneurial market process, not to explain the secrets of successful entrepreneurship itself (see Kirzner 2009, pp. 145—146). Nevertheless, the historical application of Kirznerian entrepreneurship to understanding the process of economic development remains relatively neglected. To the extent that entrepreneurial explanations of economic development have been applied to historical case studies, the predominant account is one that was first expounded by Joseph Schumpeter (1934).

Kirzner’s theoretical exposition of the entrepreneurial market process has important empirical implications for providing a more complete understanding of the rise of modern economic growth, beginning first in Western Europe. This basis for my argument, ironically, comes from one of the main sources of the continued emphasis of Schumpeterian entrepreneurship in economic development today, and exposes the deficiency of Schumpeterian entrepreneurship through a Kirznerian lens, but without referencing Kirzner himself. The source to which I’m referring is William Baumol’s “Entrepreneurship: Productive, Unproductive, and Destructive” (1990).

Though there is evidence to corroborate the fact that scholars have taken inspiration from, and built upon, Baumol’s Schumpeterian framework (see for example Li, Feng, and Jiang 2006; Henrekson and Sanandaji 2012; Aeeni, Motavaseli, Sakhardi, and Dehkordi 2019), it does not immediately follow (nor would I argue) that the relative neglect of Kirzner can be attributed to either an error of omission, or even commission, by Baumol. Nevertheless, my hope here is to use Baumol’s own argument to establish a Kirznerian basis for future research in economic development, and to propose a correct understanding of Baumol’s framework, which is far more Kirznerian than has been understood. Before doing so, it is important to briefly outline the accounts of entrepreneurship by Joseph Schumpeter and Israel Kirzner, respectively.

The Schumpeterian account of entrepreneurship emphasizes the creation of profit opportunities through technological innovation. Economic development, according to Joseph Schumpeter, “is a distinct phenomenon, entirely foreign to what may be observed in… the tendency towards equilibrium” (1934, p. 64). Therefore, the Schumpeterian entrepreneur is an innovator who has a disequilibrating effect on the market process. The Kirznerian account of entrepreneurship, however, has an equilibrating effect on the market process. In effect, the Kirznerian entrepreneur is an arbitrageur who seizes previously unnoticed profit opportunities by realizing the existence of disequilibrium due to prior entrepreneurial errors in the allocation of resources. When he perceives such inefficiency from unrealized gains from trade, the Kirznerian entrepreneur captures pure profit and exhausts gains from trade by redirecting resources from less valued consumer uses to more valued consumer uses.

“Given that, for most of its history, Europe was both a cultural and technological backwater compared to China, this empirical fact presents a puzzle that cannot be explained solely by a Schumpeterian account of entrepreneurship.”

Baumol’s central claim is that the relative allocation of entrepreneurship between productive, unproductive, or destructive activities “depends heavily on the rules of the game—the reward structure in the economy—that happen to prevail” (1990, p. 894). Thus, entrepreneurship is ubiquitous, but its manifestation is institutionally contingent (Boettke and Coyne 2003). By his own admission, however, the Schumpeterian entrepreneur, according to Baumol, is an incomplete understanding for explaining, in the words of Eric Jones, “The European Miracle” (1981 [2003]). Given that, for most of its history, Europe was both a cultural and technological backwater compared to China, this empirical fact presents a puzzle that cannot be explained solely by a Schumpeterian account of entrepreneurship. This is admitted by Baumol, who provides a Kirznerian answer as to why this is the case:

  • To derive more substantive results from an analysis of the allocation of entrepreneurial resources, it is necessary to expand Schumpeter’s list, whose main deficiency seems to be that it does not go far enough. For example, it does not explicitly encompass innovative acts of technology transfer that take advantage of opportunities to introduce already-available technology (usually with some modification to adapt it to local conditions) to geographic locales whose suitability for the purpose had previously gone unrecognized or at least unused (Baumol 1990, p. 897).

The unintended, and unexpected, economic transition of the West from subsistence to exchange was fundamentally predicated on creative arbitrage, namely (as Baumol puts it), innovative acts of technology transfer by arbitraging it from one geographic location (with a less valued use) to another geographic location (with a more valued use). These creative acts of arbitrage were facilitated by Kirznerian productive entrepreneurship, which had been uniquely adopted to the commercial demands of European commerce, and facilitated by political fragmentation and interjurisdictional competition. The result of jurisdictional competition, which redirected the relative allocation of entrepreneurship toward productive activities, expanded the scope of productive specialization and exchange through adoption of existing technology that created the conditions for economic calculation. As Rosenberg and Birdzell state this point:

  • The very idea of varying and changing what one did in response to calculations of future consequences and present conditions of supply and demand lay outside the normal pattern of medieval life. Calculation is the crucial word here. The possibility of calculation, of assessing prospective magnitudes of cost and revenue and the probability of alternative outcomes in a novel enterprise, of profiting from judicious buying and selling… rather than from diligent service to one’s lord or from industriously plying one’s trade, was wholly alien to the customary order of feudal society (emphasis original; 1986, p. 53).

Just to name a few such technological adoptions which were arbitraged from existing technology from China, but “created” for the unique commercial purposes in Europe, include bills of exchange and double-entry bookkeeping. Werner Sombart, professor of the Austrian economist Ludwig Lachmann, has gone so far as to say that “One cannot imagine what capitalism would be without double-entry bookkeeping” (1953, p. 38). Thus, the technologies that were adopted to Europe were transformed to create something that had not otherwise been seen in humanity before on such a wide scale: the transformation of competition from a form of violence to competition in the form of productive specialization and exchange. The resulting transition from poverty to wealth is a fundamentally a Kirznerian story, one that economic historians can discover, learn from, and use as an intellectual profit opportunity to correct for existing misinterpretations in economic history.