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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  1. #1 by akaWDW on January 28, 2013 - 8:39 pm

    See also “On ceteris paribus laws in economics (and elsewhere): why do social sciences matter to each other?”, Menno Rol.
    Erasmus Journal for Philosophy and Economics, Volume 5, Issue 2, Autumn 2012, pp. 27-53.

  2. #2 by Nicolai Hähnle on January 28, 2013 - 10:27 pm

    “It would be at best costly and destructive, and at worst basically impossible, to uproot these institutions in search of some ideal.”

    Don’t you mean that the other way around? 😉

  3. #4 by Prodigeek on January 28, 2013 - 10:34 pm

    I’m glad for a post I can follow. I’m not formally trained in economics by any means. Having said that I’m also very enthusiastic about understand and have spent many, many hours in thought, deducing what I can. I’ve read the likes of Moshe Adler and listened to many a talk on the subject. I understand the basic subject matter. It’s just the academic jargon that trips me up really.

    Given the fact that I am a self-proclaimed layperson when it comes to this subject, it’s very disturbing to me to see the kind of cognitive short-cuts and presumptions that are being made by people who are supposed to be much smarter than I am. It seems very obvious to me that some people have become too immersed in the rhetoric of the system to see that they’ve made very specious and dangerous assumptions. This post seems to highlight one of many.

    I think there is a disconnect. When I try to call it out, it seems as though it triggers a strawmen misrepresentations in their minds, but what I would say is that they lost track of what money and economies are supposed to represent, and what they are supposed to do for us. In fact the thought of them doing something for us (99%) has become and absurd and blasphemous notion. They are supposed to be secondary concepts; a proxy for more practical mechanics and material ends, but now we have displaces those ends with their proxy. We are serving markets and wealth for the sake of markets and wealth, and THIS has twisted the discourse on the subject.

    They WANT there to be a unified theory, because it serves market and monetary ends. It seems to me that the objections you mention are all centered around the human elements of the story, and that is why they miss it.

    It seems to be one of the greatest cognitive weaknesses of the human mind to desire simple prescriptions for complex problems. This is true of your over-arching point. It’s also true in terms of why they made that mistake in the first place. There is at first a good point to be made about not clouding logical decision making with emotional biases. But, when you take that notion too far in itself, lusting for that perfect, simple answer, you end up with an anti-sentimental bias and miss the boat altogether the other way.

    • #5 by Unlearningecon on January 30, 2013 - 11:20 am

      They WANT there to be a unified theory, because it serves market and monetary ends. It seems to me that the objections you mention are all centered around the human elements of the story, and that is why they miss it.

      Yeah, absolutely. Economists don’t seem to realise that their decision to approach things in a cold, mathematical way is itself a normative decision, and their rejection of other methods is also normative. The silly idea that they are engaging in ‘value free’ analysis transparently false considering the hissy fits some of them throw when presented with criticism of their methodology.

  4. #6 by W on January 28, 2013 - 11:46 pm

    Macroeconomics is hardly anything but institutional economics (the counterpart of microeconomics: welfare economics, dealing with distributions of given amounts of aggregate resources, as a response in changing preferences, and so on…).

    In particular, Macroeconomics is basically about monetary institutions: after the General Theory, Keynes took the political economy path of setting the foundations of post-gold-exchange-international-standard; namely, that of Bretton Woods (international fixed yet adjustable exchange rates parities).

    Instead of keeping track of such a theoretical development, mainstream, marginalism or whatever, re-built a theory out from such an approach to institutions (monetary institutions…defining macroeconomics: setting graph(theory)-like anchors-structure worldwide), again losing ground by holding an evergrowing axiom-based (unempiricall) approach.

    Fortunatelly, the work of Leijonhufvud quite substantially save not only the (monetary) institutionalist foundation of historical macroeconomics, but also that of contemporary macroeconomics.

    Take the rationale of Leijonhufvud concerning the so-called “sub-prime crisis”: for him the clue to understanding the crisis is not other than the pervasiveness of Inflation Targeting theory (tenet), enabling interest rares cuts so far as price-level remained bounded, and causing at the same time a world-wide asset-inflation…just because the post-Bretton-Woods era is pretty different from that of years now bygone…at present, the balance of payment policies of Asian surplus-countries leave the Inflation Targeting theory rather mismatched to empiricall facts, for a couple of reasons (among others…the lack of a world-standard, as previuos decades have had clearly within the Dollar).

    But instead of AL`s rationale, everyone had Krugman´s misperception of the causes of the crisis, therefore almost stubbornly asking for the US treasury to run even larger fiscal deficit, and the old Keynes` caricature on macroeconomic phenomena.

    Anyway, it takes no less than, say, a couple of years to face Leijonjufvud´s work and by so doing, rework the core of one´s conceptual-tools to deal with macroconomic knowledge.

    On another level, were the western-world going to fade in front of the rising of the eastern (asian) one, there remained afterall the work of Leijonhufvud to understand the very causes of such a fall.

  5. #7 by rumplestatskinn on January 29, 2013 - 2:00 am

    It’s like we have a parallel existence. I constantly rant about the general ignorance in the economics profession of institutional variation. Probably because there is not ‘core theory’ about institutions it seems fine to ignore them and, as you say, concentrate on the ‘underlying mechanics’ of markets. When challenged that institutions and their various laws and regulations define markets, I get agreement, but no recognition of how this challenges much of their basic economic analysis.

    Questions such as ‘what is the outcome of regulation X’ generally are analysed by first assuming that there is some perfect market that exists in the absence of any regulation, then tweaking the model to include a subjective interpretation of the behavioural reaction to regulation X. Sometimes this works, and sometimes it doesn’t.

    I’ve found even economists who proclaim some specialty in a particular area (such as land and urban economics) have little understanding of the process of developing town planing regulations, or the approvals process nested within them. They simply have in their mind an interpretation – regulation = bad = supply constraint = high cost. Yet when asked which parts of the document generate a supply constraint compared to the previous situation, or some other baseline, they rarely have a comprehensible answer.

    Some other bugbears you might want to follow up on – the economics professions generally poor interpretation of real survey data collected by statistical agencies. Whole careers are spent trying to understand multi-factor productivity, without ever understanding the whole process used to generate the data. You rarely hear an economists say that the change in the latest GDP estimate is a statistical artefact, which is true many times if you simply look at the size of revisions. They always seem to have an barrow to push and interpret the data in a way that suits their ideology.

    Rant over. Keep up the good work.


    • #8 by Unlearningecon on January 30, 2013 - 11:26 am

      Supply side versus demand side logic is such an overly simplistic view of the world that simply leaves no room for institutional considerations. For many economists, Denmark’s safety nets would be a ‘supply constraint;’ as would Japan’s employment regulations. It’s just nonsensical.

  6. #9 by isomorphismes on January 29, 2013 - 2:32 am

    It appears that underlying this methodology used by economists to evaluate and analyze collections of data is a search for unifying principles that can be applied to all economies across space and time.

    And yet the institutional economics models go Even More neoclassical in analysing costs & benefits or game theory of institutional arrangements and how they might have evolved or equilibrated. In my opinion those models are more compelling (perhaps since they’re centuries-long long-run) than using Lagrange min to explain an individual’s behaviour. The institutional models end up going much more across space & time and being “super” neoclassical (in multiple senses of the word).

    • #10 by Unlearningecon on January 30, 2013 - 10:52 am

      I think this applies to the new institutional economists that Blue Aurora mentions, but not to ones such as Lazonick who have a deep historical knowledge and don’t wish to impose any particular neoclassical structure on their work.

  7. #12 by Tom Hickey on January 29, 2013 - 3:34 am

    A good example is the mistaken assertion that the US or UK is becoming the next Greece. It is erroneous due to difference of monetary institutions. The US and UK are sovereign in their currency, hence are not revenue dependent, while Greece does not issue its own currency is revenue-dependent, similar to US states. Ignoring the institutional difference obscures the disconnect between currency sovereigns and countries that are not currency sovereigns, either using a currency that they don’t issue, running a currency board (peg) or borrowing in a currency other than their own. This is presently resulting in a huge amount of confusion.

    • #13 by Unlearningecon on January 30, 2013 - 10:50 am

      Absolutely. Even more broadly, there is the endogenous versus exogenous money debate. For example, see Krugman:

      So the critics here are mistaking a management technique the Fed uses for convenience — a management technique that it hasn’t always used in the past, and might not use in the future — as representing some kind of fundamental law about how monetary policy does or doesn’t work.

      Nobody is trying to uncover ‘laws;’ they are simply describing the system we actually live under. Exogenous money is logically possible, I suppose, but it just isn’t how the banking system currently works.

  8. #14 by Xavier Cameron on January 29, 2013 - 6:09 am

    Unfortunately, I had a longer comment here which got eaten. I’ll see if I can find it somehow.

    Your greater point here about inference across countries with difference institutions is a subset of an even larger problem–how can we extend inference from one domain to another unidentical one? Itzhak Galboa wrote an op-ed ( that I think does a great job in explaining how economists (implicitly) think about doing this. He talks about using obviously false models as “theoretical cases” that can still provide insight. It’s easy to extend this to thinking about how, say, analysis of the effect of new emissions regulation in the US may provide a case to help think about the same policy in the UK, even though the effects won’t be identical.

    By the way, I think the field has done a good job in realize how heterogeneity across domains can severely impact inference, albeit (again!) implicitly. I see this, for example, in the focus on estimating local treatment effects in labor and development studies. Perhaps I’m being generous, though.

    • #15 by Unlearningecon on January 30, 2013 - 11:07 am

      That article is interesting but he doesn’t really explore how models can trap economists, rather than illuminating problems for them. He demonstrates this with the first welfare theorem – it is a gross oversimplification to say people need to maximise utility for it to hold. It is based on an absolute fantasy of an economy and has too many unrealistic assumptions to name. Overall I’d say his attitude basically amounts to a rejection of falsification – if Walrasian equilibrium is not up for the chopping block, then what is?

  9. #16 by Blue Aurora on January 29, 2013 - 11:12 am

    Good post, Unlearningecon, but have you read anything by Ronald Coase, Armen Alchian, or Daron Acemoglu? Although all of them are part of the so-called “New Institutionalist” school of economics, they do cover institutions pretty well. I recommend getting a copy of Daron Acemoglu’s Why Nations Fail, co-authored with James Robinson. It’s a good book directed to intelligent and sophisticated non-experts in economics, and I think you can glean New Institutionalist insights from that book.

    • #17 by Metatone on January 29, 2013 - 1:33 pm

      Alas, if you look at the innovation paper by Acemoglu et al. (which they trumpet as proving an equilibrium of economic models in a world context) you’ll see that they can be pretty careless, in quite a depressing way.

      Institutional economics is largely low quality because economists are really bad at putting the effort in to actually characterise the institutions they are taking note of. (Not to mention, as in the innovation paper, that by selecting out a particular institution as having relevance and ignoring others, you can handily prove the thesis you came into the analysis with in the first place.)

      And really, that’s the general problem with economics (institutional or otherwise), economists have a bunch of buried assumptions and so very often their work turns out to reinforce those assumptions, rather than question them.

      (PS not to pick on you Blue Aurora, but I found the Acemoglu et al. paper very depressing, it suggests that progress in institutional economics is entirely hobbled by the assumptions trained into economists in university…)

    • #18 by Unlearningecon on January 30, 2013 - 10:46 am

      Yeah, as Metatone says, I’m not too Keen on New Institutionalists, as they fall into the traps I mentioned in my post. For example, Coase implies there were first markets, then firms evolved to minimise transaction costs. This completely ignores the way firms gain control over market forces: bulk buying with suppliers; retaining needed workers in the long term contracts through raises and promises of stability and promotion; advertising, marketing and promotion to ensure a steady flow of revenue.

      The internal organisation of firms often involves picking particular strategies that may be long term, and hence requires centralised implementation of plans that simply couldn’t be coordinated through market forces. Such considerations are too abnormal for neoclassical economists to consider, as they mean that a firm with market power may be good for development, rather than an inefficient interference with the perfectly competitive ideal. They also clash with the ‘black box,’ input-processing machine view of the firm.

      I have heard of WNF and admire their approach. I’ll surely purchase it at some point.

      EDIT: actually, if WNF is anything like this, I think I’ll pass. Irrelevant historical examples and an assumed thesis throughout. Not to mention fairly discontinuous prose.

  10. #19 by Metatone on January 29, 2013 - 1:41 pm

    I used to go to Tim Worstall’s blog and document all the ways he was misleading people about Sweden – but life is too short. He’s particularly bad at picking out successful public services that were public for 40 years and then assigning all the success to the last 2 years of privatisation… but there are plenty of other misrepresentations too – he’s happy to talk about federal vs local taxation when it makes his point, but very happy to obfuscate around it when it suits him.

    • #20 by Unlearningecon on January 30, 2013 - 10:30 am

      I recently tweeted that the most frustrating thing in blogging is arguing with someone, only to have them repeat their initial points back to you over and over again. I find Worstall like that. He references a wide array of ‘facts’ and feels he is knowledgeable on everything from British Feudalism to the environment to the magical creation of scarce resources. The negative review on his book I linked sums it up – reads like an A-level student who’s just taken a few classes and is ready to take on the left.

  11. #21 by Will on January 30, 2013 - 1:43 am

    It’s always good to see the institutionalist tradition get some notice. In America, there was a vibrant institutionalist school that was largely forgotten with the Keynesian revolution and Samuelson’s dominance.

    Lately it has seemed to me that the historical existence of slavery has had long-term institutional effects in every country where it was widespread. I don’t think you can model behavior, or shape effective institutions, without taking something like this into account.

    • #22 by Unlearningecon on January 30, 2013 - 10:23 am

      Yeah that’s a great point, and worryingly absent in contemporary discourse. I recall seeing this post by Madsen Pirie, which contains the passage “The rich countries did not become so by stealing wealth from others; they did it by creating wealth through trade.” People really think capitalism is human nature, and once you lift ‘artificial’ restrictions, the economy will take off, no matter the starting point.

      When I point out the history of the British (and US) to libertarians, I find many of them descend into defending it like neocons.

      • #23 by Will on January 30, 2013 - 8:28 pm

        Yeah. The institution of slavery actually provides a perfect example of the logical problems that libertarianism runs into. What is the libertarian position on slavery in, say, 1845? It’s not clear. Some libertarians still defend the right of the confederacy to secede (never mind that this secession was enacted by the three states with majority-black populations). Spooner, the libertarian at the time (and a fascinating case study), opposed slavery, but also opposed positive efforts to end it through the state! The ambivalent stance of Thomas Jefferson on the issue provides another instance — the simple truth is that “ownership” is not a meaningful concept without state institutions to enforce it, and nor are “contracts.” When you try to keep ownership and contracts but get rid of the state, you run into absurdities.

      • #24 by Unlearningecon on January 31, 2013 - 6:20 pm

        Libertarians generally endorse the ‘voluntary’ decision to sell oneself into slavery, which is absurd.

        Do you have a link to Jefferson talking about that?

    • #25 by Will on February 2, 2013 - 8:09 pm

      Ok, feel like I owe you a further comment here. Jefferson is not really in the same category as libertarian apologists for slavery. He denounces it as an evil and proposes to do away with it. However, he is ambivalent because he is so fixed in his white supremacism, and so sure blacks and whites cannot live together in peace, that he is not willing to see emancipation without a plan to resettle the former slaves:

      In later life, he counseled friends not to manumit their slaves in their wills, and upon his death, he manumitted only the slaves who were his relations.

      So Jefferson’s ambivalence simply shows an immense hypocrisy, as the man who wrote, “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain inalienable rights…”, evidently was willing to compromise that principle pretty readily.

      (It is necessary to note that many of Jefferson’s contemporaries, including George Washington, Alexander Hamilton, John Jay, John Marshall, Gouvernour Morris, and John Adams, were supportive of manumission without relocation, many of them actively so).

      • #26 by Unlearningecon on February 3, 2013 - 11:18 am

        Ah, fair enough. Thanks.

        I do always wonder why people appeal to the founding fathers so much when it’s obvious many of them were racist and flawed. Obviously everyone is flawed, but it’s been 250 years now – can we just move on?

      • #27 by Will on February 3, 2013 - 7:14 pm

        I, too, have never seen the point in viewing the “founding fathers” as a sacred oracle we can consult on any topic. But let’s be mindful: future people will likely see us as monsters, too, for tolerating any number of abusive policies. People like Washington and Hamilton weren’t infallible, but they were much better than the average leader at that time. (Hamilton’s writings, in my opinion, contain early expressions of a number of heterodox insights). It’s also worth pointing out that the “strict constructionism” associated with founder worship relies on rubbish history. Early commentary on the constitution leaves no doubt that the intent of its writers and promoters was that it be flexible and adaptable to changing circumstances and changing needs — an indication that the “founders” did not even want to have the final word.

      • #28 by Unlearningecon on February 4, 2013 - 5:35 pm

        Yeah, we should be fair to them. They were ahead of their time, but not so far that they are still relevant. Likely they would have seen this themselves. As with many things, the misinterpretation has had terrible historical consequences.

  12. #29 by Mick Brown on February 1, 2013 - 8:03 pm

    “I’m glad for a post I can follow. I’m not formally trained in economics by any means. Having said that I’m also very enthusiastic about understand and have spent many, many hours in thought …”

    That’s what your first poster said and I would like to support that.

    But would it also be possible to add the dimension of time in this? Great economists seem to describe the workings of the economic world as they see it in their own age, so that has to be taken into account as well as the institutions and their own changes over time.

    • #30 by Unlearningecon on February 2, 2013 - 12:49 pm

      Yeah, absolutely. Whether people will partake in ‘markets’ depends on how used to the social relation they are. This is why Russia had so many problems with its ‘shock’ transition.

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