AS A YOUNG MAN, Joseph Schumpeter said he had three ambitions in life – to become the finest horseman in Vienna, the greatest lover in Austria, and the most brilliant economist in the world. In later years, he confessed to being disappointed that he had only realised two of his three goals.

He did not say which two.

I’ve got a fair idea, however, of which one Schumpeter thought he had failed to achieve. One searches in vain for the name of Joseph Alois Schumpeter among equestrian medal winners in Olympic Games around the turn of the 20th century. And as – perhaps fortunately – there are no comparable objective measures of success in Professor Schumpeter’s other fields of endeavour – and since the Professor’s view of his own abilities was seldom a modest one – we may deduce that he believed his capabilities in these areas to have been outstanding.

In Sylvia Nassar’s Grand Pursuit: The Story of Economic Genius (2011), we find this account of Schumpeter’s “strangely double life” during a sojourn in London in 1901,

“His public persona was that of a gregarious, slightly flamboyant, pleasure-loving Continental aristocrat” by night, while during the day, he occupied “the austere and deliberately plebeian precincts of the London School of Economics and the British Museum’s hushed, high-ceilinged reading room, where he made a point of working at the same table where Karl Marx had composed Das Kapital” (p. 176).

Schumpeter’s vision of capitalism – first set out in his Theory of Economic Development, published exactly a century ago in 1912 – was far more accurate than that of Marx. Das Kapital omitted the essential player in the capitalist system, who was at the centre of Schumpeter’s analysis – the entrepreneur. In Schumpeter’s analysis, it is the entrepreneur who drives economic progress, by introducing innovations which offer radically improved ways of satisfying human wants.

Marx was not the only thinker to neglect the role of enterprise in economic development. It is largely absent from Walrasian models of general equilibrium, which dominate economic textbooks. Enterprise and innovation – unpredictable, discontinuous and of uncertain impact – disrupt the mathematical elegance of neoclassical models, and make them impossible to solve. Yet, as Schumpeter wrote in Capitalism, Socialism and Democracy (1950),

“In capitalist reality, as distinguished from its textbook picture, it is not competition within a rigid pattern of invariant conditions which matters, but competition from a new commodity, a new technology, a new source of supply, a new type of organisation – competition which commands a decisive cost or quality advantage and which strikes, not at the margins of the profits and outputs of existing firms, but at their foundation and their very lives.”

Schumpeter described capitalist progress as a process of “creative destruction”. The innovations promoted by entrepreneurs drive the economic system forward, but at the same time destroy existing companies that fail to move with the times.

This process of creative destruction is seen time and again, and one does not have to think very far beyond developments in information and communications technology over the past 20 years to witness it in action.

For the process to work, it is imperative that entrepreneurs – who may have very little capital themselves – have access to credit to finance their innovations. This in turn requires an efficient banking system acting as an intermediary between savers and depositors on the one hand, and investors and entrepreneurs on the other.

Today, new enterprise is being stifled because large parts of the banking system have ceased to function as efficient intermediaries between savers and investors.

In the years leading up to 2007, a sort of Gresham’s Law took hold in the banking sector, with bad banks driving out good banks. The bad banks leveraged up their limited capital aggressively, and then lent these funds to less and less creditworthy borrowers. For the most part, these loans did not support creative enterprise of the sort that Schumpeter saw driving economic progress. Instead, they supported speculative ventures, particularly in the property sector, which added nothing to the productive capacity of the economy, but merely served to create an unsustainable price bubble which gave the illusion of false prosperity.

[The process can be explained in terms of my Fundamental Equation of Banking Solvency, as set out in my comment of June 22nd on my own blog www.goldenguinea.com and originally published in a paper written more than quarter of a century ago, entitled “Dilemmas of Development Banking” (Savings and Development, Milan, Italy, 1985). The equation is:

[r – i] ≥ a + p + pr

It states that, in order for a bank to be solvent, the margin that it earns between the average rate of interest it secures on the loans it makes (r) and its funding costs (i) must be at least sufficient to cover the costs of its administration (a) and the probability of default on its loan portfolio (p + pr).]

What happened during the bubble years was that bank margins became progressively lower as banks chased new business – in other words, the value of [r – i] diminished. At the same time, the risk of default [p] increased as banks advanced money to less creditworthy borrowers, including the notorious Ninjas – borrowers with No Income, No Job or Assets.

By this process, the bad banks were digging their own graves – all the while paying the executives responsible for this disastrous strategy ever greater bonuses, based not on the quality of the loans they were making, but on their quantity.

Since the credit crunch, many of the bad banks have collapsed. Those that have survived have become increasingly risk-averse. Lending to new enterprise has slumped, and economic recovery has been sluggish as a consequence.

But there are some reasons for optimism.

A Schumpeterian process of Creative Destruction is taking place within the banking system itself. New retail banks are entering the market, breaking the stranglehold of the oligopoly which has dominated British banking for over a century of HSBC (which grew out of the old Midland Bank), Barclays, Lloyds and the NatWest in England, and RBS and the Bank of Scotland north of the border. New players such as Virgin Money, the Co-op Bank, OneSavings, and the Tesco and Sainsbury Banks, are gaining market share.

This process would be accelerated if the British Government took steps to break up the old behemoths. The Government is the majority shareholder in two of them – RBS / NatWest and Lloyds / HBOS. It is therefore in a position to insist that their retail and investment functions are formally separated, non-core activities hived off, and some of their branches sold to new entrants. Some of these initiatives are already happening – for example, the sale of 632 Lloyds Bank branches to the Co-op Bank announced in July.

Sir Mervyn King and the Bank of England are also to be commended for the action that they are taking to promote this process. While I believe that the Bank’s Quantitative Easing policy is fundamentally misplaced, its support of banking reform is absolutely correct – “if a bank is to big to fail, it is too big”, as Sir Mervyn rightly said.

Along with the extension of competition in banking, there are encouraging signs of change in banks’ lending practices. Radio 4’s series on Fixing Broken Banking comes to the conclusion that successful smaller banks – such as the Cumberland Building Society in Britain and local banks in Germany – adopt a very different approach to lending to some of their larger competitors, and as a result have experienced a much lower rate of default. Instead of automated credit scoring methods which do away with human judgement, these banks place much greater emphasis on close and enduring personal relationships with their clients.

In difficult times, the difference between a borrower who hands back the keys and disappears, and a borrower who battles through temporary debt servicing difficulties, lies not in their income or assets, but rather in their character and attitude. This is something that no credit scoring model can measure.

As competition is extended in the banking industry, and personal relationships between bankers and their clients are restored, the integrity of the banking system will slowly recover. Once that happens, funds will once more start to flow from savers to entrepreneurs, and the rate of innovation, which Schumpeter rightly saw as the driving force of economic progress, will start to increase.

Michael Nevin is author of The Golden Guinea: The International Financial Crisis, 2007 – 2014: Causes, Consequences and Cures. Commentary on the evolving international financial crisis such as this article can be found on the book's website www.goldenguinea.com