Insitutionalism and historical school of economics
Neoclassical economics was the important school of economic thinking in the economics between 1890s and 1930s. However, it was not the only school of economics in this period.
Economic science late in 19th century and in the first three, four decades of 20th century was pluralistic. There was no mainstream economics in this period.
Neoclassical economics was popular in England and France, but not in Germany and in the US.
At the time, there were at least two popular and powerful rival, to neoclassical economics, schools of economic thought active in the scientific world.
These were:
- historical school of economics
- institutional economics (or institutionalism)
Mostly German economists and some English economists represented historical school of economics, while institutionalism was immensely popular in the US.
Both schools were highly critical of various aspects of neoclassical economics. Later in the course of 20th century, from 1930s on, neoclassical economics has marginalized both schools, but late in 19th century and in the first 3 decades of 20th century neoclassical economics, historical economics and institutional economics has been competing for the rule in the world of economic ideas.
So let's review quickly the economic views of those two alternative, heterodox approaches to economics (neoclassical economics is from the modern perspective said to be the orthodox economics, since it became the most popular in the 20th century).
The members of historical school (we do not have to specify their names, they were in general German economists, publishing their works in the 2nd half of the 19th century and in the first decades of 20th century) generally criticized classical and later neoclassical economics from the point of view that those theories do not apply to all times and cultures.
They thought that the conclusions of Smith, Ricardo, Mill, Marshall and others may be valid for advanced capitalist countries such as England, but do not apply to agricultural or less advanced countries such as Germany or US (especially in the mid 19th century 1840s, 1850s.
In addition, they advocated that economics should not strive for discovering universal economic laws to be applied in all times and cultures, but rather that economists should formulate the laws governing the economy on various stages or levels of development. Therefore, economics should provide some economic laws for underdeveloped countries and a different set of laws for developed countries.
Historical school of economics was also very critical of the use of abstract, mathematical models in economics, they thought that economic science should proceed by gathering a body of historical evidence and only after enough empirical evidence had been gathered, theories should emerge.
The historical school of economics had a little influence on mainstream economics, and neoclassical economics has marginalized this school from 1930s on, but I was very influential in Germany and in effect of this economics as an intellectual discipline suffered, did not develop according to neoclassical standards, in Germany for several decades.
So much on the historical school, let's now turn to institutionalism - a heterodox school of economic thought, which was active in the US in the first 3 decades of 20th century.
The intellectual father of institutionalism is Thorstein Veblen (1857-1929).
First, his criticism of neoclassical economics.
According to Veblen, neoclassical economics is not scientific. He wanted to tear down, to abolish the entire structure of neoclassical economics and rebuild a unified social science from economics, anthropology, sociology, psychology and history.
Veblen said that all classical and neoclassical theories were based on the same assumption - that there is a harmony in the economic system - this appears in the Smith's concept of the invisible hand of market, which turns private egoisms into public benefits. Also the concept of equilibrium as used by classical and neoclassical thinkers was to Veblen not a positive, scientific concept, but rather a normative one - he thought that in orthodox theory it is implied, without proof, that equilibrium is good, desirable and that the results produced by markets in equilibrium are socially benefit. It was not proved by neoclasicals according to Veblen.
Classical and neoclassical was also unscientific to Veblen because it refused to admit that the economy was constantly changing and evolving. Orthodox economists treated economy as static, non-evolving entity. This static neoclassical theory should be replaced by dynamic analysis of the evolution of the economy and society.
Veblen suggested that economists should not only study the formation of prices on markets in a static framework, but also analyze the factors they assume to be constant - such as tastes, preferences, technology, organizational arrangements of the society and the economy and so forth.
Veblen never believed in the invisible hand mechanism described by classical economists, in which the self-interest of producers corresponds to society's public interest.
Veblen maintained that individual businessmen rather strive to gain a monopoly power on markets, and to rise prices above the competitive level. In this, they act against the social interest. Large corporations do not aim to increase efficiency and to lower the prices, but to acquire monopoly power, to restrict production and gain monopolistic profits.
He also thought that the competition among firms for international markets led to conflicts and ultimately to wars.
Businessmen (or captains of industry as Veblen called the owners of capital) strive for profits will inevitably lead do depressions and mass unemployment.
In essence, Veblen rejected the classical/neoclassical assumption of perfectly competitive markets and the idea that markets in the hands of businessmen would produce socially desirable results.
Where orthodox (classical/neoclassial) theory found harmony under capitalism with an efficient allocation of resources and full employment, Veblen found disorder, unstable economy, with businessmen who sabotage the system to make exceedingly high profits. The effect is economic depression, unemployment and international conflicts.
This is different, pessimistic vision of capitalism than that found in the neoclassical orthodox economics.
One final Veblen's criticism of neoclassical economics refers to the concept of human nature used in economics. According to Veblen, orthodox economics was ignoring the developments in psychology, sociology and anthropology, building models based upon unscientific models of human behavior.
Orthodox theory, according to Veblen, was based upon the assumption that humans are driven by the desire do maximize pleasure and minimize pains, on hedonistic psychology. Hedonism is the view that people are motivated by gaining pleasures and avoiding pains only.
According to Veblen, this assumption is wrong. People are not calculators of pleasures and pains, but have a wide array of motivations (for example various instincts, habits, obligations, duties and the like).
So the whole body of orthodox economic theory is based on the wrong, unscientific assumption and hence it is not a good economics - Veblen concluded.
So much on his critique of classical and neoclassical economics.
Now we will describe his analysis of capitalism.
According to Veblen, economic theory should be interested in something very different from the static allocation of scarce resources, which was the main subject of orthodox, neoclassical economics.
He contended that economics should be a study of the evolving institutional structure of the economy and the society. (Hence the name of the school he founded - institutionalism).
He defined institutions as habits of thought that are accepted in the society (or by different classes of society) at any particular time.
So Veblen wanted to explain those economic variables, which neoclassical economics assumed as given - that is institutions like widely-shared habits, preferences, norms and the like - in general some kind of a mental culture of capitalist society.
Therefore, if he wanted to explain the prevailing culture of the society, he needed evolutionary approach, because any culture can be understood only with reference to the past cultures it has evolved from.
The most important institutions are according to Veblen entities called instincts - well-established patterns of behavior that partly come from the past. Among the instincts he distinguished: parental instinct, instinct of workmanship (of hard work), idle curiosity, and the instinct of acquisition (greediness, money-grabbing instinct).
From the economic point of view the instincts of workmanship (hard work), idle curiosity and acquisition are the most important ones.
The instinct of workmanship make people desire to produce goods of high quality, to be concerned with efficiency in production and to put effort into work.
Idle curiosity leads to seek explanations for the world around us and to technological innovations - so it is important both in science as in the industry and the economy.
Finally, the instinct of acquisition (greediness, money grabbing) leads an individual to regard his or her welfare (or the stock of capital or money) as the only important thing, the welfare of others is ignored.
Those instinctive drives in human beings create certain tensions in the economy and the society. The instincts of workmanship and idle curiosity lead humans to produce with great efficiency high quality products that are of benefit to their fellow humans.
On the other hand, the instinct of acquisition is self-regarding only, and leads to behavior that benefits only the individual, even though it might have disastrous consequences for the society.
In the economy, in every historical period, there is a conflict, tension between the instincts of those 2 kinds.
Veblen called the activities (efficient production of high quality goods) that flow largely from the instincts of hard work and idle curiosity - industrial employments.
On the other hand, activities that flow from the instinct of acquisition are called business employments. In capitalism, business employments include above all making money.
In capitalism, there are two different habits of thought (institutions) for workers and engineers on the one hand, and for the businessmen (or capitains of industry) on the other hand.
The workers and engineers are involved on a daily basis in industrial employment - the making of goods by efficient methods. Instincts of hard work and idle curiosity are prevailing in this class of workers and engineers.
Captains of industry (businessmen, owners of capital) are concerned mainly with profits, with making money and this often conflicts with making goods, because in order to achieve higher, monopoly profits, businessman tend to reduce output, restricting the production. This is against the desire of workers and engineers to maximize the production.
So there is a basic, fundamental conflict in capitalism between capitalists and both workers and engineers.
What is important here, is that Veblen considered capitalists to produce rather ill-fare, not welfare in the society, they do not contribute to social good, but rather sabotage the social welfare, by creating monopolies, reducing the production, raising prices and the like. Veblen was a harsh critic of the class of the owners of the capital.
This division between business and industrial employments Veblen applied to discuss the consumption patterns of capitalist society. I recall you business employments are activities of businessmen - mainly money gathering, industrial employments are activities of workers and engineers - producing goods.
This application to the analysis of consumption patterns was the main topic of his book the Theory of leisure class (1899), which was widely read by intellectuals of his time.
Veblen reasoned that in every phase of the development of society people want to be held in high esteem, want to be admired. In earlier phases of development, it was possible to be admired if you were physically strong and could use violence in acquiring goods and social position. In modern capitalism, it is of course, impossible so some other methods of manifesting your predatory abilities had to emerge. The fact that you have a large income or a stock of capital is in itself not sufficient, because it cannot be so easily recognized - you cannot look into people's pockets or bank accounts.
Those methods of showing to others what your social position is are your predatory potential are according to Veblen, conspicuous consumption and conspicuous leisure.
Conspicuous consumption is the most efficient mean of displaying our predatory abilities. Our cars, houses, and especially our clothes give a clear indication of our place in the predatory order of society, according to Veblen.
If the man (or the head) of the household is too busily involved in his or her business activities, than his wife or husband is expected to display the family wealth (by dressing appropriately, avoiding work, employing large number of servants and the like).
Work in this class of people, high-income class, in general should be avoided, unless it is work in strictly business employments -firm ownership, high management, banking, finance, law - are the preferred professions.
This class was named by Veblen - a leisure class. Because the class is also engaged busily in another activity, which displays the social position accurately - that is spending the time in various unproductive, highly priced actions. This conspicuous leisure includes, according to Veblen, higher education, parties, all sporting activities and the like. For example, if you often play golf or any other time and money consuming sport it surely shows that you are rather rich.
These are conspicuous consumption and conspicuous leisure - activities of leisure class, the richest class of the society, which do not have to work, at least in the production sector. This description is to some extent rather sociological than economic, but there is probably some truth in it and likely we can see many examples of conspicuous consumption and leisure even in today's capitalist societies.
This division between business and industrial employments Veblen applied to speculation about the tendencies of capitalism in the very long run. I recall you business employments are activities of businessmen - mainly money gathering, industrial employments are activities of workers and engineers - producing goods.
He thought that since there is a widespread emulation of consumption patterns in sthe capitalist society, that is members of the lower class- workers and engineers want to engage in conspicuous consumption and leisure as far as their resources allow them to to this, than it will lead to an economy devoted to conspicuous consumption, waste flowing from consumption consumption and leisure, and increased advertising and marketing costs.
Increased advertising and marketing costs because if the consumption it the dominating theme in the capitalist society, at least in the Veblen's vision, than firms will try hard to advertise their products and bear the excessive, according to Veblen, costs, not connected to the process of production.
As long as industry is controlled by businesspeople in search of profits, we can expect the increased flow of goods, which do not satisfy real human needs, goods that impede the progress of humanity, goods specially produced for the leisure class.
However, if the working class and engineers gain the control of the system, the industrial economy might fulfill its promise of a good human life.
According to Veblen Marx was wrong. The capitalism will not collapse through the revolution brought about by the absolute poverty of the working class. It is not an absolute, but relative poverty that might be the reason for the end of capitalism.
As the economic growth is working, the working class feels being relatively poorer than the businessmen class (leisure class), and because the lower class still wants to emulate the consumption patterns of the higher class, workers and engineers want to consume the same classes of goods as the members of the higher class, it forces so much discontent on the part of the working class that it might lead to the revolution, socialist-like revolution and bring about the abolishment of the private property.
Therefore, according to Veblen socialist revolution a la Marx is possible as the future scenario of the development of capitalism, but for different reason than Marx thought.
It is the relative poverty, because people want to have more purchasing power than others, not just more purchasing power. People envy other people their standard of living.
Therefore, the supposed reason for the end of capitalism is the individuals' concern about their own relative well-being. Therefore Veblen suggests that capitalism might collapse not because of its failure as Marx thought, who held that capitalism will bring about growing unemployment, crises, depressions, increasing absolute poverty and the like), but rather because of its success . Capitalism is growing, and probably the absolute standard of living of the working class is increasing (they have more and more commodities in their possession), but the relative poverty is growing (in relation to the leisure class, they become poorer and poorer).
However, Veblen did not think that this is the only possible vision of the development of capitalism in the long run. Against Marx, he was convinced that the evolution of capitalism is not a determined process. The future is open and cannot be predicted. So the fate of capitalism and private property is uncertain.
One possibility is the socialist revolution, but there are others also.
Alternative possibility is the so-called technocratic revolution. The growth scientific and technological attitudes generated among the working class and the engineers will lead to a replacement of businessmen, so that the control of the economy will pass into the hands of technocrats (mainly engineers).
If these developments occur, according to Veblen, it will mean an end of monopoly power in the markets, end of financial manipulation on the part of the businessmen, end of conspicuous consumption and excessive advertising and industry will be so directed as to produce goods that are serviceable to humankind.
Still another possibility is that is the rise of the economic and political right-wing movements as the working class and the engineers turn themselves to nationalist ambitions and war-like aims, and democracy in this scenario will end as a police state.
Veblen, as a careful evolutionary theorist knew that the future cannot be predicted, especially in such a wide scale and the only thing he knew for sure is that the future will be different from the present state of capitalism. Therefore, he offered various possibilities for the development of capitalism - socialist revolution, technocratic revolution and vision of the democracy turning into a police state.
A summary of Veblen's views.
Veblen was a harsh critic of both capitalism and neoclassical economics, which supported capitalist system.
For Veblen neoclassical economics was unscientific and he wanted to fund a new united social science, based on the achievements of economics, sociology, psychology and anthropology - a science which would be evolutionary, which would explain mainly changes in the institutions - prevailing habits of thought in the society (like instincts).
Some people say that Veblen was not an economist at all, but a sociologist. In addition, as you maybe know for modern mainstream economists sociology is a fuzzy, imprecise social science - `a smaller tribe without a model as a totem' - as one Nobel Prize winner in economics have said. Economists generally treat other social sciences as less scientific than economics.
This view, to treat Veblen as sociologist is to some degree correct, since he himself thought that economics is not enough to understand human behavior in the field of economic activities, and wanted to build a united social science.
Moreover, he was not interested in the same set of problems as orthodox, neoclassical economists - he wanted to explain those factors, which are unexplained in mainstream economics - motives of human actions, preferences, institutional structure of the society.
In this perspective, Veblen's contribution can be regarded as complementary to mainstream neoclassical economics.
Veblen found many flaws in neoclassical economics - like unscientific concepts of invisible hand, equilibrium, unrealistic assumption of competitive markets, perfect rationality of economic agents, futile deductive and mathematical approach to the analysis of economic problems - but the alternatives he offered, his theoretical propositions, have not been very fruitful.
He built no grand model with easily identifiable assumptions and a logical structure, which would lead unambiguously to strict conclusions. He simply offered a literary description of capitalism, with no scientific model or theory.
Moreover the psychology of instincts that he used in describing human agents, has been later rejected by psychologists.
Orthodox, neoclassical economics has not been much influenced by Veblen critique. Economists still rather assume rational, calculating households or firms.
Perfectly competitive models of markets still play a profound role in theories and in teaching.
His view of o need for evolutionary economics received some attention in the last 30 years, and we have a school of evolutionary economics today, but it is not a very popular current in modern economics.
Another Veblen's contribution was a critique of neoclassical economics for being to deductive, too mathematical, not enough empirical science. Veblen wanted economists to gather as much as possible of empirical facts to test empirically economic hypotheses.
Yet Veblen's own theories were not presented in the manner suitable for empirical testing, nor did he document his statements with statistical material. His writings are amalgamation of positive (scientific) and normative assertions, he never formulated his conclusions in a precise way, which would allow other economists to empirically test his propositions.
However, this part of Veblen's criticism did, to some extent, compel economists, mainly American economists, to be more concerned with the facts, with empirical evidence, and the fantastic growth of empirical work in economic since the II world war may be partly explained as an intellectual response mainstream of economists to Veblen's critique.
Veblen's followers, other members of institutional school, in the first three decades of the 20th century in America, have pioneered the institutional collection of data for economic analysis, especially for the analysis of business cycles.
This is a significant contribution of Veblen and institutionalism.
A few words on other members of institutional school. Veblen was a founder of the school, but not the only member. The school was immensely popular in America between the year 1900 and the Second World War, only just after the war it was marginalized by neoclassical economics.
Other members of the institutional school, we do not have to mention their names, did not produce theoretical results, which would have influence neoclassical economics. They were engaged mostly in the analysis of economic policy and in this field, their impact was very significant.
All institutionalists, to varying degrees, called for much more governmental intervention in the market than it is implied by neoclassical economics. Many of their ideas, especially in the social, redistribution and labor market policies, were implemented in the US and in Britain. So they had a profound impact on the institutional structure of modern capitalism, they contributed to the increased scope of government intervention in the Western capitalism.
In the area of economic theory, they had less impact. Neoclassical economics has gained supremacy in economics in the years of the Second World War, and other currents of economic thought, became of much smaller relevance and popularity. We will see why and how this happened during the lectures devoted to the 20th century thought.
In addition, one more thing. In a sense, institutional ideas have reemerged in economics from 1970s in the so-called New Institutional Economics, which is a mix of neoclassical methodology and institutional focus on the concept of institutions. However, this school is neoclassical in this that it uses most of neoclassical econmics assumptions and analytical tools, and only applied them to the problem of economic institution. We will review shortly this school later.
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