institutionalism confronts the 1990s

Institutionalism Confronts the 1990sAuthor(s): Philip A. KleinSource: Journal of Economic Issues, Vol. 23, No. 2 (Jun., 1989), pp. 545-553Published by: Association for Evolutionary EconomicsStable URL: http://www.jstor.org/stable/4226152 .

Accessed: 28/06/2014 13:54

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

Association for Evolutionary Economics is collaborating with JSTOR to digitize, preserve and extend access toJournal of Economic Issues.

http://www.jstor.org

This content downloaded from 91.213.220.184 on Sat, 28 Jun 2014 13:54:42 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=aee

http://www.jstor.org/stable/4226152?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


J i JOURNAL OF ECONOMIC ISSUES Vol. XXIII No. 2 June 1989

Institutionalism Confronts the 1990s

Philip A. Klein

Twenty-seven years ago Clarence Ayres published an enormously optimistic book entitled, Toward a Reasonable Society [Ayres 1961]. His optimism was always a part of his perspective and sprang from a belief that economics, specifically institutional economics, in the process of discovering instrumental value had uncovered a principle that not only could potentially revolutionize economics, but merely awaited general recognition to spread from economics to the entire human experience [Ayres 1944, Chap. 10]. Enshrining instrumental value was the secret to harnessing the forces of nature and the technological process in the direction of human betterment.

It seems a good time to ask what progress we have made in the years since Ayres's optimistic forecast was enunciated. At that time the threat of nuclear annihilation was already technologically recognizable. Other potential roadblocks to the continuation of human existence, let alone progress, were well known, and yet Ayres managed to remain optimistic in spite of all. Ayres's optimism was not unlike a sophisticated ver- sion of Anne Frank's famous "In spite of everything I still believe that people are good." The line between Anne Frank's healthy optimism and Blanche DuBois's demented, "I have always relied on the kindness of strangers," is a fine one indeed. It is time to ask whether optimism

The author is Professor of Economics, Penn State University. This article was presented at the Annual Meeting of the Association for Evolutionary Economics, 27-30 December 1988, New York. The author wishes to thank Edythe S. Miller and Owen Nankivellfor helpful comments on an earlier draft.

545



546 Philip A. Klein

may still be justified. We shall not consider the whole of the human landscape, as Ayres did in Toward a Reasonable Society, but shall stick to our own discipline and ask whether it has moved any closer to making a meaningful and enriching contribution to the human condition in the past quarter century.

More explicitly, let us begin with what I believe has always distin- guished the institutionalist paradigm from that of mainstream economics. Institutionalists have reached broad agreement on the nature of their paradigm: along with the technology-institutions dichotomy, the institutionalist emphasis on the dynamic rather than the static is fundamental. The other distinction that we have done to death in the past quarter century in our never-ending attempt to "state what we are for, what is the institutionalist paradigm"-more fundamental than all other things-is the deceptively simple Veblenian notion that the role of an economy has to do with furthering "the life process." The life process is by its very nature evolving; it is the subject of endless for- mulation and reformulation. It is intrinsically non-teleological. It is the bedrock on which Ayres was able to talk about economic progress instead of mere growth [Ayres 1944]. This principle finally is what makes economics a science of valuation, not merely allocation [Klein 1974].

Obviously one of our tasks as a society is to ask constantly in what direction we wish to go, and how our resources can help us move in that direction. My greatest objection to the path that mainstream economics continues to take, and indeed takes in newly strident terms today, is its insistence that, insofar as the economy has a role to play in furthering the life process, "the market" provides virtually all the an- swers about which economists need to be concerned. Either it gives the best answer economists can imagine (frequently this takes the form of Pareto optimality and so it is described as "ideal"), or it gives the best answer of which economists think they are capable, which in practical terms comes to the same thing.

A core assertion among institutionalists is that economic performance must always be assessed against emergent societal values. More- over, institutionalists assert that economists have a pivotal role to play both in making that assessment and in the ongoing public debate that surrounds it. While no modem economy is prepared to settle for anything like total reliance on market allocation, the mainstream economics profession, certainly in its consideration of economic theory as well as a number of the major applied fields, appears to have reached new heights in its battle always either to leave valuation questions to non- economists or to take refuge in an increasingly complicated number of



Institutionalism Confronts the 1990s 547

market allocation clones (among others-cost-benefit analysis, welfare economics, public choice theory, the theory of contestable markets, or, as we shall shortly consider, rational expectations). When institutionalists insist that the economy is a valuating mechanism, not a mere price-making mechanism, they are a voice in the wilderness-mainstream economists in the Robbins tradition profess not to know what we are talking about.

The market is a useful instrumentality. No one would deny it. But it does not give direction, it takes orders, and reflects orders. Somewhere there must be (and of course there is) debate about the orders, where they originate, what they reflect, and what they lead to. Institutionalists have always insisted that it is a total abdication of responsibility for economists to argue that this lies "outside" their discipline. Assessing and analyzing the impact of the orders against evolving societal objec- tives is the essential task of the economist. If the expertise of the economists is worth anything it is to provide an especially valuable voice to debates about where the economy is headed and what the implications of such movement may be. Mainstream economists who insist on a rigid normative-positive dichotomy suggest that "leaving allocation to the market" is a value-free-hence "positive" approach (Com- pare Friedman [1953]). In fact laissez-faire is and always has been as much a value position as interventionism of whatever sort.

If I am depressed about the state of economics today it is because so much of it does not even attempt to provide economists with better equipment for this debate. Economists, as noted above, are not especially encouraged even to participate in it, nor are our prestigious graduate schools particularly concerned with equipping their graduates with a more useful voice to raise in public inquiry. Academic economics is instead devoted all too often to sterile pursuits. Far from helping formulate the life process as economic theory, much mainstream economic theory devotes itself quite literally to playing games.

Recent Business Cycle Theory-A Case Study

I ask you to consider the recent work in business cycle theory reported here as an illustration of mainstream vision. Recall that business cycle theory as such scarcely existed in the nineteenth century ex- cept in what Robert Heilbroner called "the underworld of economics." The mainstream was ruled by the Marshallian perspective dominated by "equilibrium." The economy, including the macroeconomy, was es- sentially a stable self-correcting mechanism. Early (English) business



548 Philip A. Klein

cycle theory shared much of the perspective of American institutionalism. Both represented rejection of the mainstream paradigm and re- garded the task of economic theory at bottom as being the provision of a solid basis for developing policy for the real world.

If this is all an old story I remind my audience that examples of the approach in economics illustrated here, far from diminishing, in fact multiply and present themselves in ever-more extreme form. In fact, what is happening is that business cycle theory has now been invaded by the mainstream virus. The institutionalist vision derived from the nineteenth century unstable world that was present in early business cycle analysis is being attacked by a late-twentieth century mainstream vision, a vision in my judgment that is distinctly myopic.

Recall first that much modem business cycle analysis had its genesis in the work of Wesley Clair Mitchell, a founder of institutionalism (for example, [Mitchell 1959]). A thoroughgoing empiricist, Mitchell thought the task of economic theory was to explain what was happening to the economy around us. His investigations led him to formulate a theory of business cycles that, not surprisingly, was dismissed as "mere description" by mainstream economists who also accused him of "measurement without theory" [Koopmans, 1947]. Naturally, in a world where Say's Law, the assumptions of full employment and flex- ible wages and prices led to a Panglossian laissez-faire, known in economics as Pareto optimality, it is no wonder that business cycles needed no attention. So to focus on them at all was in itself an enor- mous forward step. It was also, as noted, profoundly institutionalist.

Our colleagues in mainstream economics have not quite returned to this earlier world-business cycles are, after all, too obvious to be easily ignored, but they have managed to defang them by renaming them "real business cycles" [Long and Plosser, 1983; Brunner and Meltzer 1986], or even better, "equilibrium cycles" [Lucas 1977]. How they have managed to do this is instructive because of its implications for other fields in economics.

A recent article by Long and Plosser in the Journal of Political Econ- omy, surely one of the bastions of mainstream economics, is instructive. Entitled "Real Business Cycles," the paper begins by noting that Robert Lucas, the High Priest of Rational Expectations, asserted after examining the evidence that all business cycles have two characteristics in common: (1) the ups and downs in individual series are persistent and (2) the series appear to move together-they exhibit what Lucas called "co-movement." From this Lucas took the breathtaking leap to




the conclusion that because there is no reason in economic theory to anticipate these results, one could conclude that "all business cycles are alike" [Lucas, 1977].

Long and Plosser, illustrating beautifully the mind set of Rational Expectations adherents, proceed to argue that one can reach profound conclusions if one but makes two simple assumptions-one concerning consumer preferences and the other about production possibilities. In regard to consumer preferences, one must assume that "all dated con- sumption goods (including leisure) that are demanded in positive amounts at any given prices are strictly normal at those prices" [Long and Plosser 1983, p. 41]. With respect to production possibilities, the hypothesis is that "nontrivial capitalistic production ... is feasible and generally efficient" [Long and Plosser 1983, p. 41].

The article employs econometric techniques to show that on the basis of these two assumptions alone one can generate fluctuations not unlike those observed in the actual world. They therefore conclude that their model is consistent with an explanation that assumes rational expectations, complete information, stable preferences, no technological change, no long-lived commodities, no frictions or adjustment costs, no government, no money, and no "serial dependence in stochastic ele- ments of the environment" [Long and Plosser 1983, pp. 40-41]. This list of assumptions includes a goodly number of the objections among institutionalists to mainstream theory. But Long and Plosser think such assumptions may not be so bad after all. They argue that a model that does not violate any of these assumptions can be produced by employ- ing the econometric methods they use here. This model in turn can produce ups and downs in the data that in duration and amplitude look very much like the cycles we produce when we plot actual data.

Their basic conclusion, however, is that the persistence and the co-movement in their models "should not be confused with welfare- reducing deviations from some ideal path" [Long and Plosser 1983, p. 67]. They maintain they have described a "competitive theory of economic fluctuations" that is Pareto Efficient. ("Business-cycle phenomena .., are perfectly consistent with ideal economic efficiency" [Long and Plosser 1983, p. 43]).

If we have business cycles even "in equilibrium," then-Friedman notwithstanding-it is not because of monetary mismanagement that we have them-they are "natural." Finally we come to their policy conclusion: "Efforts to stabilize this economy can only serve to make consumers worse off," [Long and Plosser 1983, p. 68].



550 Philip A. Klein

The Role of Economic Theory

Long and Plosser's most fundamental error, in my judgment, is to follow Lucas in arguing, "One exhibits understanding of business cycles by constructing a model in the most literal sense: a fully articulated ar- tificial economy that behaves through time so as to imitate closely the time series behavior of actual economies" [Lucas quoted in Long and Plosser 1983, p. 68].

Here we come precisely to the nub of the problem. Lucas, and indeed many mainstream economists appear to be under the impression that (the most?) significant progress must necessarily have been made if we manage to simulate phenomena found in the actual world. I believe that an institutionalist must argue that while one might learn something useful-possibly even a great deal that is useful-by developing models that simulate aspects of the real world, this is not the function of theory. No physiologist would argue that a model simulating the human body is the goal of physiological research, although constructing such a model might be undeniably useful in understanding human anatomy. But the physiologist's goal is to find out how the body works so that he can understand what makes it go wrong. The real purpose is to develop techniques for improving human health.

In precisely comparable fashion a model that replicates characteristics of the actual world-let us be generous and suggest it can replicate 90 percent of the observed characteristics-is nonetheless not genu- inely useful if it does not also provide some clues to altering its operation. Just as no physiologist worth his or her salt would downplay disease, even by implication, so no sensible economist can dismiss in- stability as merely an efficient adjustment mechanism. In such a con- text what does "efficient" mean? One thing it appears to mean is that economists have not learned anything in the process of replicating "reality" that is helpful in improving its performance. In this sense it fails to achieve what I have earlier called the "higher efficiency" [Klein 1984]. In parallel fashion we would have to conclude that death is an efficient mechanism for coping with disease, famine is an efficient mechanism for coping with demographic crises, etc. A confession that we have not yet learned how to improve economic performance is a far cry from an assertion that the present operation of the economy is in some meaningful welfare sense "efficient."

This characterization of recent work in business cycles can, of course, be supplemented with comparable examples from other current fields in economics. But this example illustrates my main charge against a great deal of current conventional economic analysis. Model building




has become the be-all and end-all of theoretical efforts. In business cycles, analysis that concludes ihat efforts at stabilization will only make consumers worse off is utterly useless in a world where inflation rates swing as widely as they do in modem market-oriented economies, and in which unemployment rates in double digits are not uncommon. Pro- nouncing high unemployment "natural" may let economists off the hook to their own satisfaction, but it will never get an economy off the hook. (Interestingly, ridding an economy of high inflation by an en- forced period of high unemployment is never dismissed as "ineffi- cient"). Unless economists are prepared to define their job-description to encompass improving the functioning of the economy as well as developing complex elegant econometric models (however accurately they simulate the world) they deserve to become as irrelevant as pur- veyors of snake oil or readers of sheep entrails. At least the latter argued they could improve one's condition. If-and only if-we wish to put economic theory in the same class as chess, can the move to ever- greater disjunction between developing economic theory and developing more effective economic policy proceed undeterred.

Conclusion

I have used as illustration my own field of business cycles. But of course the New Classical Economics has a message for all fields. Pre- cisely how futile intervention in the market economy is depends on which branch of the new classical approach one adheres to. In our consideration of recent work in business cycles, we examined the Rational Expectations view, and it abjures all intervention. Other new classical economists take slightly different tacks. One could join the monetarists, who focus on pillorying monetary policy, or the supply siders, who prefer to believe that economic growth alone will wash away all our prob- lems.

The rhetoric of market reliance is, of course, quite different from reality. Even the staunchest marketeer would not choose to return our economies to the state illustrated say, by factor conditions or agricul- tural practices in the England of 1815.

People (including economists!) need a rationale for assessing the ongoing state of the economy as well as for judging the case for or against intervention, for choosing a path toward the future, for knowing how intelligently to define and redefine what at any given time we mean by "economic progress." In short, the relationship between the economy and the debate about value cannot be avoided, and economists presum-



552 Philip A. Klein

ably have the expertise to contribute fruitfully to that debate. We have already noted that "reliance on the market" is very much a value-laden position. Rigorous insistence on churning out positive economic analysis is, in the end, a road to nowhere.

After a virtual lifetime of reflection on these matters I am more con- vinced than ever that the perspective of institutionalism is the only one that makes sense. "Enhancing the life process" is what economic analysis is all about. Differentiating economic progress from economic growth is the ongoing debate to which all economists should be eager to contribute.

Instead I see entire generations of young highly trained economists emerging from our most prestigious graduate schools who come to tell their "stories" invariably encapsulated in "models" built on "stylized facts." (This customarily means a world so neatened up and simplified as to be easily captured in a series of fairly simple simultaneous equa- tions. These can be solved to yield high correlation coefficients which, it is implied, we should all find impressive). These efforts are filled with assumptions that perhaps oversimplify more than is customary in other social sciences that feel some obligation to focus on the actual world. In any case, in economics this work rarely enlightens us about how to make economic activity enrich human life, other than to argue that whatever we have been doing has probably been a mistake. Murray Weidenbaum summarized this mainstream view neatly recently. Eco- nomic policymakers are, he noted, in effect exhorted by the command, "Don't just stand there, undo something" [Weidenbaum n.d., p. 8].

I believe that we can do better. Institutionalists have a perspective and a paradigm. In my 1977 Presidential Address to AFEE I com- plained that institutionalism is largely ignored by the economics profession [Klein 1978]. I see no reason to alter that judgment. Indeed, as I have suggested there is considerable evidence that economics has been moving further away from the institutionalist perspective. Whether, therefore, it has a meaningful future is a question I prefer to leave to others.

References

Ayres, Clarence E. 1944. The Theory of Economic Progress, Chapel Hill: Uni- versity of North Carolina Press.

-. 1961. Towards A Reasonable Society. Austin: The University of Texas Press.

Brunner, Karl and Meltzer, Allan H., eds. 1986. Real Business Cycles, Real Ex-




change Rates and Actual Policies, Carnegie-Rochester Conference Series on Public Policy, Volume 2536.

Friedman, Milton. 1953. Essays in Positive Economics. Chicago: University of Chicago Press.

Klein, Philip A. 1978. "American Institutionalism: Premature Death, Perma- nent Resurrection." Journal of Economic Issues 12 (June 1978): 251-76.

. 1974. "Economics: Allocation or Valuation?" Journal of Economic Is- sues 8 (December 1974): 785-81 1.

. 1984. "Institutionalist Reflections on the Role of the Public Sector." Journal of Economic Issues 18 (March 1984):45-68.

Koopmans, Tjalling. 1947. "Measurement Without Theory." Review of Eco- nomic Statistics, 29 August 1947. Reprinted in Reading in Business Cycles. Ed. R. A. Gordon and L. R. Klein. American Economics Association, Home- wood, Ill.: Richard D. Irwin 1965, pp. 186-203.

Long, John B. and Plosser, Charles I. 1983. "Real Business Cycles." Journal of Political Economy 91 (February 1983): 39-69.

Lucas, Robert E., Jr. 1977. "Understanding Business Cycles." In Stabilization of the Domestic and International Economy. Ed. Karl Bruner and Allan H. Meltzer. Carnegie-Rochester Conference Series on Public Policy 5. Amster- dam: North Holland.

Mitchell, Wesley Clair. 1959. Business Cycles and Their Causes. Berkeley: Uni- versity of California Press, 1959.

Weidenbaum, Murray. 1988. "U.S. Manufacturing in the 1990s." Conference on U.S. Manufacturing, Washington, D. C. Unpublished.



institutionalism confronts the 1990s

Documents