2006 Reports

Toward a Model of Innovation and Performance Along the Lines of Knight, Keynes, Hayek and M. Polanyí

Phelps, Edmund S.

Capitalist systems are private-ownership systems distinguished by openness to implementing new commercial ideas - ideas for new products and methods - and by decentralized, pluralistic mechanisms for selecting the ideas to finance and providing the needed capital and incentives. The economic system in the U.S. is broadly of that type. The sort of system in continental western Europe is so constrained by institutions and regulations intended for the protection of stakeholders and “social partners” that it goes by other names - corporatism or the social market economy. China’s system must be called “state capitalism” because its financial sector is state-run. How these three systems affect innovation and economic performance is a topic of lively discussion today.

To many proponents - Schumpeter, for example - and critics - Marx, for one - capitalism’s strength is its dynamism - the readiness and adeptness with which it moves forward. No doubt this dynamism derives in part from the creativity of business people and the acuity of the financiers judging which entrepreneurial ideas to back. Yet our understanding of the mechanisms and economic institutions involved, and why capitalism’s dynamism is apparently hard to match, has not advanced far since the seminal insights of the early modern theorists of capitalism - notably Knight, Hayek and M. Polanyi.

I first review their legacy, which is not widely known. I then sketch elements of a model building on their insights, examine some of its implications and discuss recent and postwar experience from its perspective.