A fundamental premise of economic theory, dating back to Joseph Schumpeter, is that, over a sufficiently long period of time, old firms are displaced by new ones. As one saying that Schumpeter cites goes: “three generations from overalls to overalls.” In this process, known as the Schumpeterian process of “creative destruction,” new innovation is incessantly created by new firms that replace old innovators, including the most successful ones. This process is widely recognized as a driving force behind long-term economic growth. While extensive research has elucidated the importance of innovation and firm entry in fostering growth, less scrutiny has been devoted to the corresponding replacement of incumbents.  Do large, established firms truly get replaced over time, or do they maintain their dominance despite the theoretical benefits of replacement?

In a recent manuscript titled “Impediments to the Schumpeterian process in the replacement of large firms”, forthcoming in the Journal of Finance, we investigate why, across many countries and over extensive periods of time, including a century-long horizon, the largest firms often retain their dominant positions, thereby defying the expected turnover that Schumpeter envisioned. Earlier empirical investigations link the lack of replacement to lower economic growth. Such evidence gives rise to an important question: if the replacement of incumbents is so beneficial, why is it so infrequent?

Our study investigates several explanations. Schumpeter himself suggests that large incumbent firms remain large by continuously reinventing themselves, leveraging their financial strength to innovate. Alternative views are articulated in the work of early 20th-century thinkers Louis Brandeis and Lincoln Steffens. Brandeis condemns “money trusts” formed through interlocking directorates (specifically, the networks of intertwined board memberships with financial institutions) that stifle competition and enable incumbents to suppress rivals. Steffens highlights the systematic capture of political institutions by big business, which manipulates regulation to serve private interests rather than the public good. These views suggest that political entrenchment, rather than superior market performance, underpins the persistence of dominant firms.

Our findings strongly support this latter explanation: political connections, defined as instances in which one of a large firm’s top officers, directors, or blockholders is a member of parliament or is a government minister, materially enhance large firms’ ability to maintain their dominant status. Firms embedded within political networks exhibit significantly higher probabilities of remaining among their countries’ largest firms even over extended periods of time. Crucially, our analyses refute the notion that politically connected firms are able to maintain their dominant market position simply because they outperform their competitors. Various performance metrics reveal that politically connected firms, if anything, underperform their peers instead. Especially, large politically connected firms remain among the very largest firms because of greater protective political influence. This is especially the case in countries characterized by regulatory barriers consisting of tariffs, quotas, and restrictions on cross-border capital flows, which insulate large domestic incumbents from competition. In more open economies, where such barriers are not present, political connections lose their protective power, and the forces of competitive displacement lead to the demise of old large firms.

Summarizing, while innovation remains a crucial engine of growth, our research cautions that entrenched political power combined with protectionist policies can impede the natural Schumpeterian process of replacement of large firms, dampening economic growth.

Analyses

Our empirical investigation spans two periods: circa 1910 to 2018, and 2000 to 2018. For the most extensive period, we undertook a meticulous scouring a vast array of business directories to identify the largest 20 firms by book equity across 60 countries circa 1910. This effort required manually compiling detailed data on each large company to construct complex variables such as political affiliations and interlocking directorates. The more recent period benefits from richer commercial databases, including Worldscope, enabling analyses of innovation, productivity, board interlocks, and political connections. The study tracks whether large firms remain among their countries’ largest and evaluates how innovation, board interlocks, political connections, and regulatory contexts influence this persistence – – a core element of Schumpeter’s creative destruction process.

Replacement of Large Firms (or Lack Thereof)

Among the largest 20 firms (by book equity) in each of 60 countries circa 1910, 13.6% remained among the largest 20 in 2018, showing that firm replacement is common but incomplete. Firm size and age in 1910 strongly predict a large firm remaining among the largest, whereas innovation has a surprisingly muted effect. Political connections substantially increase the ability of large firms to remain among the very largest, even after controlling for various firm characteristics, government ownership, and industry sector. Conversely, bank-board interlocks, hypothesized by Brandeis to facilitate dominance, also exhibit a very muted role. These patterns suggest that political connections underpin the long-term dominance of large incumbent firms and inhibit the renewal process that Schumpeter foresaw.

In a case study, which focuses on Italy’s industrial landscape beginning in 1911, when 25.7% of firms were politically connected, we investigate how the introduction of laws and decrees in 1943-1944 that were meant to sever ties to the historical fascist political apparatus affected the ability of large politically connected firms to remain dominant. We document that, following the collapse of the fascist regime in 1943-1944, firms that exogenously lost their political connections became substantially more likely to lose their dominant positions.

From 2000 to 2018, 43.8% of the largest 20 firms in each country remained among the largest, showing more limited turnover in a shorter period. Innovation, measured by patents and R&D, positively influences persistence but less so than firm size or political connections. During this time interval, politically connected firms were more than twice as likely to remain among the largest firms than unconnected ones, despite not exhibiting superior profitability or productivity. Bank-board interlocks displayed modest significance in this short time frame. Overall, political connections, alongside firm size, exert a powerful role in explaining firm dominance, thus dampening the competitive dynamism essential to the process of creative destruction.

Political Connections, Regulatory Barriers, and Firm Entrenchment

Our analyses further show that political connections enable large firms to remain among the largest over extended periods of time, although primarily so in countries that simultaneously restrict both cross-border trade and cross-border capital flows. Firms in sectors traditionally shielded from foreign competition, such as banking and utilities, exemplify how regulatory barriers to trade and capital flow amplify the ability of large politically connected firms to remain among the largest in their countries even over a century. Falsification tests confirm that restricting either trade or capital flows alone is insufficient; both types of barriers are necessary for political connections to allow large firms to remain dominant. Openness to foreign competition thus emerges as a critical factor that counterbalances political entrenchment, promoting the replacement of firms, including the very largest firms.

Revisiting Early 20th-Century Debates in a Contemporary Context

This study revisits debates from Schumpeter, Brandeis, and Steffens regarding the forces shaping firm dynamics and economic growth. While Schumpeter emphasized innovation-driven displacement, Brandeis and Steffens underscored the perils of concentrated financial power and political capture.

Our evidence shows that, while intrafirm innovation and board interlocks sustain big business power over short periods of time, political connections, especially when combined with regulatory barriers to competition, play a pivotal role in enabling large firms to resist replacement even over extended periods encompassing multiple generations – – i.e., a century. The severing of political connections that followed the collapse of Italy’s fascist era provides compelling quasi-experimental evidence of how political capture impedes the process of replacement of large firms.

Overall, we document that, in open markets free of political and regulatory interference, in the long-run, the Schumpeterian process of creative destruction tends to prevail, facilitating economic growth. Conversely, political interference and protectionism, by stifling competition, hinder long-term economic growth. By analyzing a century of data encompassing 75 countries, our research substantively contributes to contemporary discussions about rising corporate concentration and diminishing competition globally.