Posts Tagged Economic History

Institutions and Economics

Recently, I’ve been reading a lot from the school of institutional economics. Consequently, I have noticed another problem with the way economists approach theory and evidence: the lack of institutional considerations. This can blind economists to the fact that they may be studying entirely different phenomenon due to differences between countries, periods of history, companies, genders, cultures and much more.

The standard procedure of economists is to derive a model ‘rigorously’ based on a set of assumptions or axioms. Economists, unlike physicists, cannot perform controlled experiments in order to verify these models; instead, empirical corroboration entails the use of econometrics to verify predictions. Economists must rely on collections of data, sometimes from disparate sources, and try to ‘correct’ these collections of data for said disparities. They then perform regressions in an attempt to isolate the relationship between two variables, and cautiously interpret the results. However, the problem with this approach is that institutional differences could mean that some of the data in question are simply irrelevant, whether or not they disagree with the predictions of the theory in question. 

Problems with this Methodology

It appears that underlying the methodology used by economists is a search for unifying principles that can be applied to all economies across space and time. Both the neoclassical and heterodox schools reflect a discipline aiming to isolate the ‘true’ mechanics of the economy and build a model around it. The mentality often seems to be that, if only we could isolate these true mechanics, we’d be able to understand the economy and make informed policy decisions based on our ideal framework. I’m sure many economists would agree that the institutional, legal, and cultural contexts are not the same for all economies. However, many economic models and the economist’s rhetoric reflect a discipline looking to uncover an equivalent of physical laws. Indeed, Larry Summers went so far as to claim that “the laws of economics are like the laws of engineering. One set of laws works everywhere.”

Even though most rational minds would disagree with Larry Summers, I find there is a tendency among economists to imagine that the institutional, legal, and cultural contexts are viewed as ‘constraints’ against which the ‘underlying mechanics’ of the economy are continually pushing. However, there is good reason to believe that the ‘real’ mechanics of the economy are determined by the context in which the economy operates, rather than said context merely influencing the economy exogenously. Here are some historic and contemporary examples to illustrate my point.

Industrialisation: the US versus England

English firms were fairly small during the industrial revolution. For reasons beyond the scope of this blog post, firms typically took it upon themselves to educate and train new employees on the job. Such a system diminishes the need for state education, at least from a labour market standpoint, and it wasn’t until the late 19th century that public education was finally established, by which time England was industrialised and the old system was becoming obsolete. In contrast, the USA followed a different path. During the growth period of the US, firms generally emphasised large production lines, and had a more ‘flexible’ approach to employment. Such an approach required that firms could rely on the competence of the average worker, and over the course of the US industrial revolution state education increased substantially, reaching something approximating a fully public system at around the same time as England, even though England was much later in its development phase. Both strategies successfully industrialised their countries; both presented different needs from a policy perspective. But using a single model to inform policy in these two countries would clearly be a mistake.

A similar contrast can be seen with Denmark and Japan. Historically, Japan has had a policy of lifelong employment, which means a majority of workers are, well, employed for life (the model may be waning due to the effects of the lost decade, but it was robust during Japan’s impressive industrialisation period). What would be the effect of restrictions on hiring and firing with such a model? It’s highly unlikely there would be much effect; in fact, the model itself is partly based on such regulations. But what if similar restrictions were applied to Denmark’s dynamic ‘flexicurity‘ model, in which hiring and firing is incredibly easy but there are strong social safety nets? I expect it would cause a lot of problems for employers and employees alike, as Danish firm’s strategies are built around being able to gain and shed workers quickly. On top of that, the safety net makes workers more willing to accept such treatment, as well as having obvious humanitarian attractions.

Again, though these two models are different – almost diametrically opposed, in fact – both have coped with recessions relatively well (in terms of unemployment). The countries simply have different institutions that operate under different mechanics, and no model could capture both (feel free to read that as a challenge). Despite this, Japan has recently enacted some ‘neoliberal’ reforms, perhaps based on the mistaken belief that they need to ‘free up’ the ‘underlying’ mechanics of the economy. Time will tell whether or not this was a smart move.

The Scandinavian Ideal

Apart from labour markets, there is another good example of interdependent institutions, laws and culture: the oft-cited Sweden. Both free marketeers and leftists like to hold Sweden up as an example of their ideas in action. “Look at the vast redistribution, unions and public goods!” Is the cry of the leftists. Meanwhile, the rightists will assert that beneath such institutions lies a relatively light touch, ‘neoliberal’ regulatory structure. In any many ways both are right; but in many more ways they are both wrong. Both approaches take the economy of Sweden and suggest that due to X, Y or Z policy, it is the way to go. But neither appreciate how the institutions identified by both fit together.

Sweden is historically a high-trust society and as such regulation is relatively simple. Even contract law is far less complex than that you will find in the UK or the States. Many businesses do something akin to ‘self regulation,’ reporting their own data to government agencies. Similarly, while it is questionable whether the generous welfare state is a cause of the trust, it is not unreasonable to suggest that the two are complementary. Furthermore, as in the case of Denmark, generous safety nets go well with light regulation in terms of dynamism. The approach has serious attractions, but only if the two institutions are combined: furthermore, it may well be the case that trust is a necessary condition for both of these institutions in the first place. Once more it is clear that certain historical circumstances have given rise to a specific set of ‘optimal’ policies that could not be applied elsewhere.

So if we take data points from between such disparate countries, is it really meaningful to try and ‘adjust’ them for this type of difference? What we are studying are economies with very different underlying mechanics. To aggregate over them and take the average result is to reduce the data to meaninglessness. What is needed is a historical, institutional perspective that understands how different aspects of the economy fit together, and how the economy fits into the background of politics, history, culture (not to mention to environment – for example, on an island country, even a corner shop can be a monopoly).

What is best for an economy will depend on initial conditions and current institutions. These institutions are not ‘artificial’ impositions on the underlying economy; they are inevitable political decisions which have been born out of specific historical context, and hopefully fit the culture of the nation in question. It would be at best costly and destructive, and at worst basically impossible, to uproot these institutions in search of some ideal. As such, any discussion of economic policy must proceed based on acknowledgment of the mechanics created by different institutions.

Much of what I’m saying isn’t new at all. In fairness, most empirical economic papers are careful about announcing they have found surefire causal links. And there might be new techniques in econometrics that attempt to deal with the problems in the methodology I outlined above. Furthermore, I am not suggesting economists are not at all concerned with institutions or history: development economists and Industrial Organisation economists speak of them frequently. Nevertheless, I believe the institutional considerations I described above create a clear methodological problem for large amount of economic theory, particularly macro.

This is because institutional considerations are a good reason that social scientists should be even more concerned about assumptions and real world mechanics than the physical sciences, and therefore that economists should be highly concerned with the historical, institutional and legal context of the economies they are studying. Such considerations are another nail in the coffin of Milton Friedman’s methodology, which posits that abstract models based on “unrealistic” assumptions are the appropriate approach to economic theory. Such an approach cannot even begin to comprehend institutional differences, and as such, applying any one theory – or group of theories – to every economy is bound to cause problems.

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A Brief Anti-Economist History

Here are a few historical facts that I consider to be both true and contrary to what most economists (and libertarians) think. All have substantial historical evidence behind them, whereas I find the opposing case generally relies on just so stories. All 3 cast considerable doubt on pro-capitalist stories about trade and development. (I would use bullet points but wordpress seems to be in a mood. You’ll have to imagine them):

Rich countries did not get rich through free trade, but through the use of protectionism and other state interventions such as capital controls and subsidies. This includes but is not limited to: the UK, US, Germany, Japan and Scandinavian countries. Furthermore, more recently developed countries got rich by doing something similar, and in the case of the Southeast Asian ‘Tigers,’ the intervention was even more explicit, with state employees working inside the infant industries. There are a couple of exceptions such as the Netherlands, but even in their case their initial rise was characterised by large state backed monopolies in order to overcome transaction costs. Finally, supposed bastions of free trade such as Singapore and Hong Kong are both characterised by various public provisions, and Singapore has a large GSE sector. The go to accessible source on this is Ha-Joon Chang, though others are also available.

Money did not arise as a solution to the ‘double coincidence of wants,’ a highly improbable concept that begs a lot of questions (such as ‘how exactly does the cow farmer get all his inputs?’) Money primarily arose as a form of credit, and this was intertwined closely with social relations and kept communities bound together. Credit only became ‘exact’ once it was enforced by force rather than social pressure, and evidence suggests the use of coins and notes primarily followed the introduction of taxation. Before this, the overwhelming majority of barter was rare and between different tribes/nations, and often accompanied by feasts, sex and violence (sometimes all at the same time!) The primary source on this is, of course, David Graeber. I have not seen a convincing critic, though not for want of trying (‘it might have happened even if there’s no evidence!’ and ‘but debt is just delayed barter’ respectively).

Peasants did not freely move from their land into 12+ hour days in factories because it was ‘better than the alternative.’ In many cases they had their land taken by foreclosure acts and their hunting severely restricted by game laws. Prior to the industrial revolution they had plenty of problems – they were particularly susceptible to disease and famine – but evidence suggests they had a far greater degree of leisure and control over their working conditions than wage labourers. Michael Perelman’s book gives an in depth treatment of this, and similar arguments can be found throughout marxist writings.

The conclusion is clear, and something I have said before: western capitalism is neither harmonious nor natural. It is a product of specific historical circumstances, some of which were incredibly brutal. Any libertarian who accepts this (and some do) – presuming they adhere to a broadly Nozickean conception of justice – should take a deeply skeptical stance of everything that followed (e.g. the modern world). In fact, most libertarians should probably be revolutionaries.

P.S. This post is partially inspired by Robert Vienneau’s similarly formatted post on economist’s misinterpretation of the history of thought, worth a read.

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How Natural is Capitalism, Exactly?

The standard libertarian narrative of capitalism goes something like this: once various feudal restrictions were lifted and property rights were fully defined, people indulged in their ‘natural propensity to truck, barter and exchange’ and economic freedom fuelled growth. Conditions were poor for workers, but were better than the alternative. To tamper with capitalism and the free market is to tamper with the nature of man.

It is first worth considering the existence of an entity called the ‘free market’. But the fact is that people simply see the ‘free market’ where they want to, ignoring certain rules and regulations. To start, the workings of an economy are massively affected by the definition of property; what types of property are deemed private, as well as the definition of fraud and the workings of the criminal justice system. Secondly, laws like limited liability, immigration restrictions and laws that protect shareholders are often swept under the rug.

I feel the idea of a ‘free market’ greatly skews the views of its proponents, as they see something as complicated as the transition in China as simply them ‘unleashing’ the free market, and also write catch-all sentences like this:

It is worth remembering that the epicentre of the 2008 disaster was American property, hardly a free market undistorted by government.

Which, to me, simply makes no sense. I mean, the crisis was undeniably focused on private institutions, and if you’re going to start blaming government laws then you’ll logically have to end up blaming ones like limited liability laws, laws that define corporations, and possibly even private property itself.

I believe some have tried to argue that the black market represents a type of free market, but I’m not sure how possible that is given the amount of customs and arbitrary rules you often find there, not to mention the considerable amount of force.

Furthermore, the idea that trade springs up wherever man is and money initially arose as a solution to the ‘spot trade’ problem created by mankind’s natural propensity to ‘barter, truck and exchange’  has been falsified spectacularly by the anthropologist David Graeber, who revealed that there are 0 examples of barter arising spontaneously; money first arose primarily as a form of debt, and ultimately was a social relation.

On top of this, the historical origins of capitalism, at least in places, are hardly as magical as its defenders would have you believe. The industrial revolution involved large amounts of collusion between landlords and capitalists, and produced a surge in game laws, designed to limit peasant’s ability to subsist and hence create a workforce dependent on wages. The emergence of capitalism and the wage system was also closely intertwined with slavery and colonialism, and the facilitation of trade has required strong political institutions, rather than simple property rights and contracts.

Not only this, but almost every developed country had to use protectionist policies to get rich. This has been extensively documented by many scholars – the only potential examples of countries that got rich without much protectionism are the Netherlands and Hong Kong (which is effectively the London of a country currently using highly protectionist policies, anyway). I have attempted to offer a theoretical grounding for this here, but whether or not my argument convinces you does not change the historical facts.

My inclination towards capitalism is still ‘the worst system except all others that have been tried’, but the fact is that capitalism is a highly planned system with a questionable history – there is nothing ‘natural’ about it. Now this doesn’t tell us much about whether we should accept it here and now, but it makes statements such as “Capitalism is what people do if you leave them alone” rather questionable.

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Libertarianism Versus Public Choice Theory

One of the points on my much maligned third ‘double standards’ post (incidentally, maligners, read these two if you haven’t before) was the following:

10. The state is useless at doing anything. We don’t, however, question its ability to define property and enforce contracts effectively.

as well as this:

4. Historical context matters for gold as a medium of exchange. The historical context of capitalism, however, can be swept under the rug.

This got me thinking: public choice theory potentially blows a massive hole in libertarianism, despite being one of the key components in their arsenal.

The history of capitalism offers a natural experiment in how public choice considerations affect the provision of private property and contracts. To put it simply: the private property has been distributed among a select few who have used it to perpetuate wealth inequalities. Contracts have become infallible to the point where ancient laws/traditions such as laws against usury and debt jubilees are currently unthinkable, politically speaking. Private owners of capital used the state to force peasants – who, in the 14th century, worked about a quarter of hours that the average person does now – to work 12 hour days in factories. Landlords have blocked any attempt to tax away their unearned rents.

In fact, the extent of the collusion between the state and capitalist/rentier class in the provision of private property makes overcharging pharmaceutical companies and mortgage lending GSEs look like childsplay in comparison.

Of course, you can argue against public choice theory on the grounds that politicians aren’t rational self-maximising robots, and do have some sense of public duty. You could also argue from a practical perspective – we need to put institutions in place to combat corruption. But this would be opening the door to all sorts of statist policies.

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