Institutional economics

• 1. Introduction

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  Institutional economics has a founding provocation dated 1898, when Thorstein Veblen published an article titled "Why is Economics Not an Evolutionary Science?" The title was a challenge aimed at a discipline that pictured people as steady, calculating actors inside stable markets. With that article Veblen became a precursor of today's evolutionary economics. The school that grew around his challenge studies how institutions shape what people want, what they expect, and what they do.

  Three puzzles run through the story. Can anyone explain a person's tastes without asking where those tastes came from? What becomes of the free market when giant corporations help create the demand they serve? And how did a school with so many famous names end up accused of meaning almost nothing at all?

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• 2. A Different Starting Point

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  Walton H. Hamilton supplied the school's name and core elements in a 1919 article in the American Economic Review. The original focus came from Veblen, who built it on instinct. He divided society into technology on one side and a "ceremonial" sphere on the other.

  Classical economics looked at exchange between actors in markets, or at income flowing through an entire economy by way of factors of production. Institutional economists looked inside productive units instead. They treated each one as an organization of people living in a society. That shift gave the school a broad reach across the social sciences. It also gave the school an empirical interest in real interactions. Abstract models built on homo economicus, the purely self-interested economic actor, could not explain those interactions.

  In this view a market is the outcome of many institutions interacting, including individuals, firms, states and social norms. Traditional institutionalists refuse to shrink institutions down to tastes, technology and nature. Tastes, habits, motivations and expectations of the future help create institutions, yet institutions also limit and shape them. People who live and work inside institutions every day come to see the world through them.

  So the school does not assume stable preferences, perfect rationality and equilibrium. It studies learning, evolution and bounded rationality, the idea that human reasoning has limits. In the first part of the 20th century this was a central part of American economics, and it attracted economists as different as Veblen, Wesley Mitchell and John R. Commons.

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• 3. Veblen's Targets

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  Thorstein Veblen (1857-1929) wrote his first and most influential book while teaching at the University of Chicago. The Theory of the Leisure Class appeared in 1899. It asked why people under capitalism display their riches so openly, and it answered that conspicuous consumption is a way of demonstrating success. Veblen aimed the same critique at conspicuous leisure.

  In 1904 came The Theory of Business Enterprise. Veblen drew a line between industrial production, which aims to make things people use, and business, which uses or misuses industrial infrastructure to earn profit. He argued that the first is often held back by the second. In his account, business practices and monopolies restrict output and slow technological advance. Firms protect their existing capital investments and lean on excessive credit, and depressions follow. Business control of political power, he added, pushes up military spending and leads toward war.

  Neither book called for change. The first criticized consumerism and the second criticized profiteering. After the Wall Street Crash of 1929, and through the decade before it, Veblen's warnings about wasteful consumption looked sound. So did his insistence that an economy needs reliable financial institutions.

  Another economist from mid-Western America, John R. Commons, would turn from critique toward negotiation.

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• 4. Law and Conflict

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  John R. Commons (1862-1945) pictured the economy as a web of relationships among people whose interests diverge. Monopolies, large corporations, labour disputes and fluctuating business cycles all sat inside that web. The parties nonetheless shared an interest in settling their disputes. He gathered these ideas in Institutional Economics, published in 1934.

  Commons believed government should act as mediator between conflicting groups, and he lived by that belief. He devoted much of his time to advisory and mediation work on government boards and industrial commissions.

  In 1924 he published Legal Foundations of Capitalism, which made law and economics a major theme of the school. Ever since, scholars have argued heatedly about how law, a formal institution, affects economic growth. That emphasis on legal foundations still marks traditional institutionalism and its modern counterpart, institutionalist political economy. Both examine the evolutionary, habitual and deliberate processes by which institutions are built and then changed. John Dewey and Daniel Bromley stand beside Veblen in that line of study.

  Commons's contemporary Wesley Mitchell took the school in the direction of measurement.

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• 5. Technology Versus Tradition

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  Wesley Clair Mitchell (1874-1948) studied under Veblen, the economist J. L. Laughlin and the philosopher John Dewey. He became known for empirical work on business cycles. He also guided the National Bureau of Economic Research through its first decades.

  Clarence Ayres (1891-1972) was the principal thinker of what some call the Texas school of institutional economics. He built on Veblen with a split between "technology" and "institutions". The split separated the inventive parts of an economic structure from the inherited parts. Ayres claimed that technology always runs one step ahead of socio-cultural institutions.

  Dewey's philosophy shaped Ayres heavily. Both men used the instrumental theory of value. Under it, something has value if it enhances or furthers the life process of mankind. That test, they held, should guide decisions about future action.

  Yet Ayres may not have been an institutionalist in any ordinary sense. He tied institutions to sentiments and superstition, so they played only a residual role in a theory centered on technology. Hegel influenced him strongly, and Ayres gave institutions roughly the role that "Schein" had for Hegel, a word suggesting deception and illusion. For that reason some prefer to call his position "techno-behaviorist".

  Adolf Berle would carry similar questions about power into the law of the company.

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• 6. The Accountable Corporation

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  Adolf A. Berle (1895-1971) was among the first authors to combine legal and economic analysis. His work is a founding pillar of modern corporate governance. Like Keynes, he attended the Paris Peace Conference in 1919. Unlike Keynes, he resigned his diplomatic job, unhappy with the terms of the Versailles Treaty.

  In 1932 Berle and Gardiner C. Means published The Modern Corporation and Private Property. The book traced how big business had grown inside the contemporary economy. It argued that the people who controlled big firms should be held to account.

  Company law statutes decide whether directors answer to shareholders. They may grant rights to elect and fire management, call for regular general meetings, or set accounting standards. In 1930s America the typical company laws, such as Delaware's, did not clearly require such rights. Berle argued that unaccountable directors were therefore likely to funnel profits into their own pockets and to manage in their own interests. Most shareholders in big public companies were single individuals with scant means of communicating, so they were divided and conquered.

  Berle served in Franklin Delano Roosevelt's administration through the depression. He was a key member of the so-called "Brain trust" that developed many New Deal policies.

  In 1967 Berle and Means issued a revised edition. Its preface asked what the corporate structure was really meant to achieve, beyond the split between controllers and owners. The preface opened with a jab: "Stockholders toil not, neither do they spin." Shareholders, it said, are "beneficiaries by position only." Their place could be justified only on social grounds, and only by spreading wealth more widely. The ideal was a position held by "every American family" in some fragment.

  A younger economist would later ask whose preferences a giant corporation truly serves.

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• 7. Private Planners

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  John Kenneth Galbraith (1908-2006) worked in Roosevelt's New Deal administration. He wrote later than the earlier institutionalists and developed his ideas further. Throughout the late twentieth century he stayed critical of orthodox economics.

  In The Affluent Society, published in 1958, Galbraith argued that voters who reach a certain material wealth begin voting against the common good. He used the phrase "conventional wisdom" for the orthodox ideas behind the resulting conservative consensus.

  Big business, he said, makes the classical picture of markets unrealistic. Large firms set their own terms and spend their combined resources on advertising to support demand for their own products. Individual preferences therefore mirror those of entrenched corporations. Galbraith called this the "dependence effect". The whole economy ends up geared toward irrational goals.

  In The New Industrial State he argued that a private bureaucracy plans economic decisions. This "technostructure" is made of experts who work the channels of marketing and public relations. The hierarchy serves itself, profit is no longer the prime motivator, and even managers are not in control. Corporations detest risk, so they need steady growth and stable markets. They recruit governments to supply them through fiscal and monetary policy.

  While this technostructure is served, public space is starved. Galbraith pictures a person stepping from penthouse villas onto unpaved streets, and from landscaped gardens into unkempt public parks.

  Economics and the Public Purpose, from 1973, offered his remedy. He called for a "new socialism", which he equated with social democracy. It would nationalize military production and public services such as health care. It would also impose disciplined salary and price controls to reduce inequality and hamper inflation.

  The school's later heirs took a quite different route.

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• 8. Heirs and Critics

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  The new institutional economics emerged in the later 20th century. It drew on fresh theory about organizations, information, property rights and transaction costs. Its aim was to fold institutionalism into newer developments in neoclassical economics. Behavioral economics became another hallmark, built on psychology and cognitive science instead of simple assumptions about economic behavior.

  Daron Acemoglu, Robert H. Frank, Warren Samuels, Marc Tool, Geoffrey Hodgson, Jonathan Nitzan, Shimshon Bichler, Elinor Ostrom, Anne Mayhew and Gunnar Myrdal are all linked to the school. So is Galbraith. Even the sociologist C. Wright Mills was highly influenced by the institutionalist approach in his major studies.

  Karl Marx divides the camp. Some institutionalists count him as one of their own because he described capitalism as a historically bounded social system. Others reject his definition of capitalism. They see markets, money and private ownership of production as changing over time, but through the purposive actions of individuals.

  Critics go further and say the word "institution" is too central to all social science to serve as the banner of a single school. The vague meaning, they argue, has fed a never-ending dispute over who counts as an institutionalist. The same confusion hangs over what the core theory is. On this reading, the school grew popular because it can mean whatever a person wants. Some critics add that the label was misplaced from the start. Veblen, Hamilton and Ayres put technology first and gave institutions a secondary place, which makes their position arguably anti-institutional.

  Thaler and Sunstein supply one reply. They hold that a person is generally better described as a Human than as an Econ, a creature mainly concerned with self-interest. Institutional economics, in line with them, sees people as social beings who belong to a community. The Metaeconomics Frame and Dual Interest Theory go further and argue that institutional and neoclassical economics must be integrated.

  The field now has its own journals, including the Journal of Economic Issues and the Journal of Institutional Economics, where that argument can be followed.

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