institutionalism and the new classical economics

Institutionalism and the New Classical EconomicsAuthor(s): Philip A. KleinSource: Journal of Economic Issues, Vol. 20, No. 2 (Jun., 1986), pp. 313-323Published by: Association for Evolutionary EconomicsStable URL: http://www.jstor.org/stable/4225712 .

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JJOURNAL OF ECONOMIC ISSUES Vol. XX No. 2 June 1986

Institutionalism and the New Classical Economics

Philip A. Klein

An old expression says, "If it ain't broke, don't fix it." Economists by the drove have recently taken this message to heart and concluded that in the industrialized market-oriented economies we have spent a disas- trous half-century trying to fix systems that have nothing wrong with them after all. My generation was taught that John Maynard Keynes's special genius was to develop macrotheory on which useful macropol- icy might be based. His unique contribution was to drop the unrealistic assumptions adhered to so tenaciously by his neoclassical fellow economists-Say's Law of Markets and full employment of all resources in all but the most trivial short-run and self-correcting circumstances. Economists of the fifties and early sixties specialized in attacking Say's Law. In retrospect, institutionalists missed a golden op- portunity to make a point with the mainstream. Say's Law requires, if it is to remain both valid and operational, that the economy-including both its technological and institutional underpinnings-function smoothly. The possibility that a technologically producible supply and an institutionally sanctionable demand might not at all times mesh per- fectly is something that any institutionalist would have expected but

The author is Professor of Economics, The Pennsylvania State University, University Park. This article was presented at theAnnualMeetingoftheAssociationforEvolutionary Economics, New York, 27-30 December 1985. The author wishes to thank Will Mason and MonroeNewman for helpful comments on an earlierdraft.

313



314 Philip A. Klein

that neoclassical economists, with their fixation on market clearing, have had trouble confronting.

Like their neoclassical predecessors, the new classical economists, particularly adherents to rational expectations (RE), no longer attack Say's Law, because in fact Say's Law once more represents for them the state of grace into which market economies naturally fall. The failure of markets to clear continuously was a major assumption of Keynes- now newly questioned. Just mix the notion of a natural rate of unemployment into the current brew, and the full employment assumption of neoclassical economics in the pre-Keynes period is re-anointed and placed once again in a pivotal position in macroeconomic analysis. If existing unemployment is voluntary, no one need worry. All this raises an interesting question: was persistent unemployment as a problem requiring attention a figment of Keynes imagination? Is it in fact true that the 25 percent of the American labor force out of work at the depth of the Great Depression can be said to have been essentially "voluntarily" unemployed, in the sense that lower wages could have employed them? Or was there, as Keynes thought, something essentially wrong with the way the macroeconomy was functioning at that time?'

The answer to this important question lies in what one assumes to be given in the institutional structure within which economic decision making occurs. We suggest that institutionalists have always been better able to consider the institutional milieu in analyzing the macroeconomy than have mainstream economists.

The Institutional Character ofthe Keynesian Message

Some institutionalists have debated whether or not Keynes was an institutionalist.2 We need not decide this issue to note that the Keynes of the General Theory had one characteristic in common with institutionalists: a penchant for facing the economy as in fact it was, and work- ing at explaining how it functioned. In this he resembled, for example, Wesley Clair Mitchell, who insisted that economic theory could be use- fully developed only if first we get "the main facts of economic his- tory."3

Keynes's view of unemployment as a problem requiring action began with one realistic premise-namely, persistent, large-scale unemployment. Thus, if one wishes to argue that economics as a science is a deductive process beginning from "realistic" premises, one could say that both Keynes's premise and his methodology filled these requirements. Or, one could argue, as would a rational expectations adherent, that



The New Classical Economics 315

Keynes's theory was not realistic because the premise was false-in fact, markets, including labor markets, do clear, and therefore a "realistic explanation" for unemployment must begin there.

Therefore, if one argues today that sound theory derives from logical deductive reasoning based on realistic premises, it is clear that the differences emerge from (1) how one concludes a premise is realistic, and (2) how close the realistic premise need be to the deductive chain presumably derived from it. Clearly, institutionalists would argue that Keynes was trying to explain the world in a more comprehensible way than are the new classical economists. If some consider this proposition debatable, it does not seem so to institutionalists. We shall consider this below.

The New Classical Response to Keynes

The objections to Keynes by the new classical economists are well known. But it is important to underscore that all under the new classical label do not agree, nor necesarily make the identical charges against Keynes's analysis. Monetarists, for example, think interventionist policy may do more harm than good, and thus advocate their celebrated simple monetary rule as a substitute for discretionary monetary policy. Supply-siders object to interventionist fiscal policy on grounds that tax increases will usually do more harm through dampening incentives than good through stabilization.

This leaves rational expectations adherents as the major challengers to the conventional Keynes message of deficient aggregate demand and underemployment. Today the common charge is that Keynes "erred" in failing to emphasize that without assuming price (and wage) rigidity, none of the implications of his analysis-most particularly, persistent underemployment and the positive role to be played by purposeful interventionalist policy-could hold up.

Institutionalists ought to have a clear response to this line of attack because, as already suggested, the Keynesian approach seems appropri- ate to institutionalists because it assumed an institutional world we all could recognize, not one we could recognize only after a large number of assumptions were dropped.

A new assertion to the effect that "markets clear" cannot seem very promising to an economist examining labor markets in the 1 930s, un- less one ascribes to voluntary unemployment a level of importance that only new classical economists appear willing to assert.4 Any notion of a minimum wage is admittedly an institutional standard, just as what



316 Philip A. Klein

constitutes "adequate standards of living" is an institutional matter. Keynesians argued that unemployment was widespread and that expectations of wage adjustments alone were unlikely to solve the matter. In this connection, it is interesting to consider the view of a high priest of RE, Robert E. Lucas, Jr.:

I suspect that the unwillingness to speak of workers in recession as enjoy- ing "leisure" is more a testimony to the force of Keynes's insistence that unemployment was "involuntary" than a response to observed phenom- ena. One doesn't want to suggest that people like depressions! Of course, the hypothesis of a cleared labor market carries with it no such suggestion, any more than the observation that people go hungry in cleared food markets suggests that people enjoy hunger.5

If one wears the market-clearing equilibrium blinders of the stereo- typic pre-Keynesian neoclassical economists, one can presumably be impressed with this new classical argument-the concern of the economists would indeed end with noting obstacles to market-clearing. Re- source allocation according to the rules of narrowly defined efficiency exhausts the responsibility of the economist.

A fundamental tenet of institutionalist thought is that resource allocation must be judged in light of what I have elsewhere called the higher efficiency. This refers to the ability of total resource allocation to reflect fully changing societal values, including notions of equity, security, compassion, and freedom along with economists' usual concern with narrow efficiency.6 I must have had Lucas unconsciously in mind when I wrote, "Mainstream economists argue that confronting ... imperfec- tions is not part of the economist's job, or that the task can be finessed by relying on Pareto optimality, or that it can simply be ignored."7

There is, quite simply, for mainstream economists, a very clear divi- sion of labor: economists concern themselves with market clearing, in this case, of labor, and someone else worries about the level of wages at which the market clears. Rational expectations adherents would have contented themselves, presumably, with claiming that the 25 percent of the labor force unemployed at the depth of the depression existed only because the 75 percent employed were still being paid too much-or al- ternatively, that the unemployed needed to drop their wage demands to what the market would have paid. There was some wage level at which no unemployment would have existed! Would they have starved at these wages? Would their standard of living have been below what pre- vailing institutional standards of economic security required? To ask these questions-we would be told-is to move beyond economics.




Professor Lucas's comment concerning whether people go hungry in cleared food markets can be taken to its logical extreme: to ask whether people die of starvation (let alone enjoy going hungry) in cleared food markets is to raise a non-economic question.

An Institutional View ofExpectations Fomaion

Unlike mainstream economists, institutionalists have not been en- gaged in a traumatic reexamination of their notions of expectations formation. They do not claim to have a perfect theory of how economic agents form their expectations, but they have a consistent point of view and a set of assumptions that have been building at least since Thor- stein Veblen irritated his contemporaries by talking about the role of in- stincts in human motivation. The debate over whether expectations are adaptive or rational is largely misplaced in the institutionalist framework where the emphasis has always been on dynamic or proces- sual analysis. If economic analysis is single-mindedly pointed toward static equilibrium, then the relationship of prior views and prior events toward the determination of that equilibrium is a major concern. Simi- larly, the way agents view future events that might impinge on the equilibrium would be important.

The relative virtues of institutional analysis in this regard are obvious. Being fundamentally dynamic, institutional analysis of how economic activity unfolds cannot be undertaken at all without recog- nizing that the only significance attached to the present is that it hap- pens to be where we are now. To understand it, however, requires recognition that current attitudes are tied to past views and events, and are equally tied to future events by a complex of expectations. It is the continuous unfolding of the process in each of us, and the meshing with those of all other economic agents and with exogenous events that si- multaneously produces the future and determines whether the expectations of economic agents will be realized.

Institutionalist views of expectation formation begin with the premise of technological change as a dynamic conditioning factor constantly altering the potential of the economy, the relations among all economic agents dependent on the technological base, and the conse- quent ways in which, at least potentially, the participants in economic activity will be interrelated. Moreover, technology changes in ways that constantly alter the basic tension that exists in any society. The origin of the tension is the relative advantages and disadvantages that technological change alters. And the changing nature of social tension makes



318 Philip A. Klein

itself manifest in institutional response-both resistance and accommodation-to the technological change. That part of this institutional response involves processes resembling game theory is no sur- prise to institutionalists. With changed circumstances as the given, the way in which A perceives B's response, in light of what B thinks A still perceives, etcetera, can easily be factored into the process. The complex of interactions which constitutes institutional adjustment to technological change must, therefore, ineluctably involve expectations and changes in expectations.

How does this view differ from the mainstream view? Just in the recognition that it is human beings doing the interacting, that their reac- tions, including their expectations, involve their constantly changing values and that the process by which values change cannot be reduced to anything so mechanistic as the assumption that "agents use all information efficiently." This is tantamount to arguing that institutional adjustment is always and at all times a narrowly "efficient process." Recall the passage in which Ayres quoted Veblen, "It still remains to prove whether machine technology will prevail or whether our civilization will provide another tragic instance of the triumph of imbecile institu- tions over life and culture."8

While I realize that this is probably the first time Veblen has been drawn into the debate about rational expectations, the point seems nonetheless apt. If the direction of the adjustment process of institu- tions to technological change is more or less predictable, as institutionalists have always insisted, this does not mean that the rate of adjustment can be viewed as smooth or "efficient," if by "efficient" one nmeans that none of the adjustment process is ever delayed for longer that the irreducible minimum for the impact of technological change to make itself felt. A large part of the adjustment process must involve learning from the past and changing one's views about the future-in short, changing expectations. Policy makers can perhaps use the assumptions about the direction of change in setting policy. The lags in the adjustment process, and in the rate at which expectations change, explain part of the policy failures, but one need not argue that the adjustments are so inefficient as to render all policy efforts definitionally futile.

Changes in expectations reflect changing values. These involve the attitudinal changes encompassed in the higher efficiency. What an economy is charged to do is respond to the emergent values of its participants as they involve all five of the basic dimensions of the totality of economic performance which are subsumed in the higher efficiency.9




One may ask, what has all this to do with the debate about rational expectations? The answer here is, quite simply, "Everything." The RE- view of human nature is the old simplistic view embedded in Economic Man and utility maximization, reduced to tautology. Flesh and blood individuals process information in complex ways-ways colored both by their subjective view of what they see happening around them in the institutional environment, and by how they interact with that environment, and it with them.

The RE approach restores to Economic Man much of the precision and the mechanistic perfection that most of mainstream economics as well as institutionalism would have denied half a century ago. The RE Man is simply Jeremy Bentham's Pleasure-Pain Machine raised to new heights of precision via his accurate and complete processing of all available information (probably with a PC). Economic life in an RE world conjures up a vision of millions of individuals plugged into their computers in the process of rendering dispassionate decisions on a complex of factors, carefully processing endless streams of information. The institutionalist would ask, where is the impulse shopper, the price gouger, the lover suddenly driven to extravagant purchase, the tax- payer hell-bent on beating the government at its own game, the stock purchaser who has a hunch, the unemployed father, suddenly over- come with frustration, resorting to stealing or cheating, the apprehen- sive consumer fearful of a rise (or fall) in prices? One may say that all these flesh and blood participants in economic life (which have influ- enced institutionalist analysis from the beginning) will wash out in the macroeconomy. But they don't. If many larger movements in the economy are knowable, in the sense that expert economic analysis enables us to predict better than a naive forecast, many are not-naive forecasts are sometimes still the best, and small disturbances still cumulate into large disturbances. Thus purposeful interventionalist policies still have a contribution to make.

In sum, mutual interaction influences both the individual and the institutional environment. This process is necessarily complex. It is the way emergent values are produced, and it determines not just how efficiency, narrowly defined, changes, but how the other dimensions of the higher efficiency, change over time.

It is also the way one must approach the question, how will the economy respond to a given change in policy? The response is not so unpre- dictable as to sterilize interventionist policy in advance, but it is also not so precise as to reduce the reaction patterns to precise, predictable equilibrium paths. This may be one way of suggesting that public policy



320 Philip A. Klein

may always have difficulty fine-tuning the economy, but there is no reason to conclude, therefore, that the tuner of the economy cannot, like the piano tuner, make it sound much better than it did before any tuning was tried. To an institutionalist, part of the economist's job is to analyze how and whether the economy allocates resources so as to achieve minimal standards of all the criteria by which the total allo- cational thrust of any economy must be judged-the higher efficiency.

In short, Keynes was right. If one defines persistent unemployment as a problem requiring intervention, it means that the system is very likely to allocate labor in such a way as to leave a significant part of the labor market either unemployed for a long period of time or employable at wages below institutionally sanctionable levels (or, one might add, in- adequately trained, inappropriately trained, or socially regarded as "un- trainable"). This gives economic meaning to the term. One can argue that insofar as the allocation of labor within the current institutional mileu is concerned, the economy is not operating satisfactorily. Effi- ciency narrowly defined, in short, does not comprehend fully the higher efficiency.

The "Natural Rate of Unemployment"- FudgeFactorfor theBlackBox

Of all the recent additions to the apparatus of classical theorizing (both pre-Keynesian and recent) none has been more pernicious and ul- timately self-serving than the notion of the "natural" rate of unemployment. What is the natural rate? Paul Samuelson and his new co-author, William Nordhaus, are telling students that the natural rate is "The unemployment rate at which pressures on wages are to balance, tending to neither increase nor decrease the rate of inflation."10 Hence, one could derive the natural rate empirically-anytime one finds efforts to reduce unemployment further are associated with an increase in inflation, one knows that unemployment has already been reduced to its natural rate.

The use of the word "natural" is interesting-it is surely deliberate. Blacks have been described as "naturally" musical, dyslexics as "naturally" stupid, sufferers from Parkinson's disease as "naturally" jittery, men as "naturally" aggressive, etcetera. In all this mixed bag of exam- ples the world naturally is used to suggest that no known purposeful action was or had to be taken to produce the postulated condition and, by the same token, since the unemployment condition is natural, policy designed to overturn it is not likely to be effective. Changing "natural" conditions is difficult, if not impossible, so whether "natural unemployment" is good, bad, or indifferent we had best learn to live with it.




And so to call unemployment of a given rate "natural" is at once to suggest it cannot be reduced and to absolve economists from significant responsibility for searching for ways to reduce it. Accordingly, if the inflation rate must be reduced to whatever rate we target (including zero), through policies selected to achieve this end, the associated unemployment (whether resulting or merely concomitant) is simply the way things are." l

The only way economists can so reason is to use an exclusively market-clearing mentality focus on prices and quantities and "equilibrium" to the exclusion of all the other criteria that institutionalists in- sist are as critical for judging economic performance as the narrow market efficiency reflected in market clearing.

Rational expectations adherents have made a large impact by charg- ing that the Keynesian system cannot explain the stagflation of the 1970s.

Keynesian orthodoxy or the neoclassical synthesis is in deep trouble, the deepest kind of trouble in which an applied body of theory can find itself. It appears to be giving seriously wrong answers to the most basic questions of macroeconomic policy. Proponents of a class of models which prom- ised 31/2 to 4/2 percent unemployment to a society willing to tolerate annu- al inflation rates of 4 to 5 percent have some explaining to do after a dec- ade such as we have just come through. '2

But the assumptions that markets clear has seemingly not presented any problems at all for Rational Expectations adherents. The unemployment rate in the United States was 3.2 percent in 1929 and did not again achieve this level until 1943. RE adherents pillory Keynes, who set out to explain this persistent unemployment, and instead persuade mainstream economists that thirteen years of excessive unemployment rates was "voluntary" and hence not really an economic problem. A mention of voluntary unemployment for thirteen years is a small blem- ish on the RE world. But the stagflation of the 1 970s presumably was the death knell for Keynesianism.

There is surely some irony in this state of affairs. To modem mainstream policy makers inflation reduction looms far larger than unemployment reduction. And our major "solution" to unemployment is what it was in the pre-Keynesian world-simply assume it away. "Mar- kets clear"-including labor markets. What problem can there be?

Conclusions

An implication of the foregoing argument is not that every word writ- ten by Keynes should be chiselled in granite. Rather it is that the Keynesian perspective was essentially sound-one must analyze the



322 Philip A. Klein

economy as it in fact operates rather than the economy we might like to investigate. The ultimate implication of the new classical economics is to narrow once more the focus of the economist to a world that resem- bles the world about us only if one engages in heroic simplification via assumption, and if one severely restricts the obligations of the economist qua economist.

Institutionalists are driven to argue that analysis which is restricted to market-clearing, in which equilibrium is the exalted "end," in which the natural rate of unemployment can comprehend any amount of mis- ery for the worker, and the goal, in contrast, of inflation control must be a rate of price increase of 0 percent, is fatally flawed. In short, when the prime means of confronting the distance between the narrow efficiency of resource allocation and the higher efficiency-the ability of total resource allocation to reflect fully the changing societal value structure- is simply to ignore it, no economist can legitimately rest content and conclude that the responsibilities of economic analysis have been ful- filled.

Notes

1. Milton Friedman in a well-known argument has labor supply depend on the nominal wage rate divided by the expected level. Labor demand, however, depends on real wages. In the end labor can be "fooled" into volun- teering the wrong amount of labor. Could this have continued for thirteen years? (Compare M. Friedman, "The Role of Monetary Policy," American Economic Review 58 (March 1968): 1-17.

2. Among those who think he was not an institutionalist one finds promi- nently the name of Allan Gruchy. "Unlike the neo-institutionalists, Keynes and the Keynesians do not have a theory of capitalist development or a theory of industrialization. On this point they do differ from their orthodox Marshallian predecessors." Allan G. Gruchy, Contemporary Economic Thought (Clifton, New Jersey: Augustus M. Kelley, 1972), p. 334. Wendell Gordon takes another view, probably shared by many institutionalists, saying of Keynes's General Theory: "The theory was, at least initially, a fine healthy antidote to some of the sterotypes of price theory, especially the one that pure competition (and free enterprise), can be counted on to deal to best advantage with the business-cycle problem." Wendell Gordon, In- stitutional Economics (Austin: The University of Texas Press, 1980), p. 124.

3. Mitchell has argued this many times. See, for example, Business Cycles: The Problem and Its Setting (New York: National Bureau of Economic Re- search, 1927), p. 2. The debate about the requirement that economic theory be realistic, and so relevant, is very old. Lionel Robbins argued many years ago that useful economic analysis required strict adherence to deductive




logic. Provided always that the original premise was grounded in the real world, the results of deduction could be applied to that world. In this connection he ridiculed the institutionalists, including particularly Mitchell, who tried to average diverse measures of variables in different time periods to find truths pertaining to the real world. Robbins, writing in the 1930s, concluded: "A few isolated thinkers, using the despised apparatus of deductive theory, have brought our knowledge of the theory of fluctuations to a point from which the fateful events of the last few years can be explained in general terms, and a complete solution of the riddle of depressions within the next few years does not seem outside the bounds of probability." Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: Macmillan Co., 1946), p. 115.

4. An alternative and less stringent interpretation might be that rational expectations adherents don't really assume that markets clear either, but that this assumption is a more convenient and useful assumption to begin from than the Keynesian assumption. This is the Keynesian neo-classical debate revisited.

5. Robert E. Lucas, Jr., "Understanding Business Cycles," in Studies in Busi- ness Cycle Theory (Cambridge, Mass.: The MIT Press, 1981), p. 226.

6. Philip A. Klein, "Institutionalist Reflections on the Role of the Public Sec- tor," Journal of Economic Issues 18 (March 1984): 45-68.

7. Ibid., pp. 61-62. 8. Clarence E. Ayres, The Theory of Economic Progress (Chapel Hill: The

University of North Carolina Press, 1944), p. 176. The quote is from T. Veblen, The Instinct of Workmanship (New York: The Viking Press, 1914), p.25.

9. Compare Philip A. Klein, "Institutionalist Reflections on the Role of the Public Sector," Journal ofEconomic Issues 18 (March 1984): 45-68.

10. Paul A. Samuelson and William Nordhaus, Economics, 12th Edition (New York: McGraw-Hill, 1985), p. 911.

11. Say Samuelson and Nordhaus concerning options for reducing the natural rate of unemployment, "we must enter a cautionary note: two decades of research and labor market experiments ... have led objective analysts to be extremely modest in their claims ... It seems unlikely that a reduction of more than a few tenths of a percentange point could be accomplished by a set of politically acceptable reforms." Samuelson and Nordhaus, Eco- nomics, p. 222. They do acknowledge that it is a "central flaw in modern mixed capitalism" (p. 258).

12. R.E. Lucas, "Tobin and Monetarism," Journal of Economic Literature 19 (June 1981): 559-60.



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