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.