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Economics and Personal Financing > Economic Policy: Influential Theories > Flashcards

Economic Policy: Influential Theories Flashcards

classical economics

a group of early economic theories that focus on the establishment of economic freedoms

to work together to meet a goal

laissez faire

the belief that governments should not be involved in economic affairs

monetarianism

an economic policy that promotes stability through influencing the money supply

Keynesian economics

an economic policy that promotes increase of aggregate demand, particularly by increasing expansionary policies

the invisible hand

the idea that the economy naturally becomes more efficient as people pursue their own self-interests

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26.2 The Policy Implications of the Neoclassical Perspective

Learning objectives.

• Discuss why and how economists measure inflation expectations
• Analyze the impacts of fiscal and monetary policy on aggregate supply and aggregate demand
• Explain the neoclassical Phillips curve, noting its tradeoff between inflation and unemployment
• Identify clear distinctions between neoclassical economics and Keynesian economics

To understand the policy recommendations of the neoclassical economists, it helps to start with the Keynesian perspective. Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment. The Keynesian response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap. The neoclassical economists believe that the Keynesian response, while perhaps well intentioned, will not have a good outcome for reasons we will discuss shortly. Since the neoclassical economists believe that the economy will correct itself over time, the only advantage of a Keynesian stabilization policy would be to accelerate the process and minimize the time that the unemployed are out of work. Is that the likely outcome?

Keynesian macroeconomic policy requires some optimism about the government's ability to recognize a situation of too little or too much aggregate demand , and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. After all, neoclassical economists argue, it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurring—and those preliminary estimates may be revised substantially later. Moreover, there is the question of timely action. The political process can take more months to enact a tax cut or a spending increase. Political or economic considerations may determine the amount of tax or spending changes. Then the economy will take still more months to put into effect changes in aggregate demand through spending and production. When economists and policy makers consider all of these time lags and political realities, active fiscal policy may fail to address the current problem, and could even make the future economy worse. The average U.S. post-World War II recession has lasted only about a year. By the time government policy activates, the recession will likely be over. As a consequence, the only result of government fine-tuning will be to stimulate the economy when it is already recovering (or to contract the economy when it is already falling). In other words, an active macroeconomic policy is likely to exacerbate the cycles rather than dampen them. Some neoclassical economists believe a large part of the business cycles we observe are due to flawed government policy. To learn about this issue further, read the following Clear It Up feature.

Clear It Up

Why and how do economists measure inflation expectations.

People take expectations about inflation into consideration every time they make a major purchase, such as a house or a car. As inflation fluctuates, so too does the nominal interest rate on loans to buy these goods. The nominal interest rate is comprised of the real rate, plus an expected inflation factor. Expected inflation also tells economists about how the public views the economy's direction. Suppose the public expects inflation to increase. This could be the result of positive demand shock due to an expanding economy and increasing aggregate demand. It could also be the result of a negative supply shock, perhaps from rising energy prices, and decreasing aggregate supply. In either case, the public may expect the central bank to engage in contractionary monetary policy to reduce inflation, and this policy results in higher interest rates. If, however economists expect inflation to decrease, the public may anticipate a recession. In turn, the public may expect expansionary monetary policy, and lower interest rates, in the short run. By monitoring expected inflation, economists garner information about the effectiveness of macroeconomic policies. Additionally, monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation. This information is necessary for making decisions about financing investments.

Expectations about inflation may seem like a highly theoretical concept, but, in fact the Federal Reserve Bank measures, inflation expectations based upon early research conducted by Joseph Livingston, a financial journalist for the Philadelphia Inquirer . In 1946, he started a twice-a-year survey of economists about their expectations of inflation. After Livingston's death in 1969, the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan, the American Statistical Association, and the National Bureau of Economic Research continued the survey.

Current Federal Reserve research compares these expectations to actual inflation that has occurred, and the results, so far, are mixed. Economists' forecasts, however, have become notably more accurate in the last few decades. Economists are actively researching how inflation expectations and other economic variables form and change.

Visit this website to read “The Federal Reserve Bank of Cleveland’s Economic Commentary: A New Approach to Gauging Inflation Expectations” by Joseph G. Haubrich for more information about how economists forecast expected inflation.

The Neoclassical Phillips Curve Tradeoff

The Keynesian Perspective introduced the Phillips curve and explained how it is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run. By contrast, a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment. Figure 26.6 (a) shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, in Figure 26.6 (b), is a vertical line, rising up from 5% unemployment, at any level of inflation. Read the following Work It Out feature for additional information on how to interpret inflation and unemployment rates.

Work It Out

Tracking inflation and unemployment rates.

Suppose that you have collected data for years on inflation and unemployment rates and recorded them in a table, such as Table 26.1 . How do you interpret that information?

Step 1. Plot the data points in a graph with inflation rate on the vertical axis and unemployment rate on the horizontal axis. Your graph will appear similar to Figure 26.7 .

Step 2. What patterns do you see in the data? You should notice that there are years when unemployment falls but inflation rises, and other years where unemployment rises and inflation falls.

Step 3. Can you determine the natural rate of unemployment from the data or from the graph? As you analyze the graph, it appears that the natural rate of unemployment lies at 4%. This is the rate that the economy appears to adjust back to after an apparent change in the economy. For example, in 1975 the economy appeared to have an increase in aggregate demand. The unemployment rate fell to 3% but inflation increased from 2% to 3%. By 1980, the economy had adjusted back to 4% unemployment and the inflation rate had returned to 2%. In 1985, the economy looks to have suffered a recession as unemployment rose to 6% and inflation fell to 1%. This would be consistent with a decrease in aggregate demand. By 1990, the economy recovered back to 4% unemployment, but at a lower inflation rate of 1%. In 1995 the economy again rebounded and unemployment fell to 2%, but inflation increased to 4%, which is consistent with a large increase in aggregate demand. The economy adjusted back to 4% unemployment but at a higher rate of inflation of 5%. Then in 2000, both unemployment and inflation increased to 5% and 4%, respectively.

Step 4. Do you see the Phillips curve(s) in the data? If we trace the downward sloping trend of data points, we could see a short-run Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates. If we trace the vertical line of data points, we could see a long-run Phillips curve at the 4% natural rate of unemployment.

The unemployment rate on the long-run Phillips curve will be the natural rate of unemployment. A small inflationary increase in the price level from AD 0 to AD 1 will have the same natural rate of unemployment as a larger inflationary increase in the price level from AD 0 to AD 2 . The macroeconomic equilibrium along the vertical aggregate supply curve can occur at a variety of different price levels, and the natural rate of unemployment can be consistent with all different rates of inflation. The great economist Milton Friedman (1912–2006) summed up the neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: “[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.”

In the Keynesian perspective, the primary focus is on getting the level of aggregate demand right in relationship to an upward-sloping aggregate supply curve. That is, the government should adjust AD so that the economy produces at its potential GDP, not so low that cyclical unemployment results and not so high that inflation results. In the neoclassical perspective, aggregate supply will determine output at potential GDP, the natural rate of unemployment determines unemployment, and shifts in aggregate demand are the primary determinant of changes in the price level.

Visit this website to read about the effects of economic intervention.

Fighting Unemployment or Inflation?

As we explained in Unemployment , economists divide unemployment into two categories: cyclical unemployment and the natural rate of unemployment , which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP—giving potential employers less incentive to hire. When the economy is producing at potential GDP, cyclical unemployment will be zero. Because of labor market dynamics, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers. We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. Most economists do not consider frictional unemployment to be a “bad” thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some natural unemployment and this is what the natural rate of unemployment measures.

The neoclassical view of unemployment tends to focus attention away from the cyclical unemployment problem—that is, unemployment caused by recession—while putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential GDP. To put it another way, the neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers, to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), economists can design policy to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.

Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, with a vertical aggregate supply curve determining economic output, then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right—keeping the price level much the same and inflationary pressures low.

If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 26.8 shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD 0 to AD 1 to AD 2 . As the macroeconomic equilibrium rises from E 0 to E 1 to E 2 , the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 26.8 in reverse, as the aggregate demand curve shifts from AD 2 to AD 1 to AD 0 , and the equilibrium moves from E 2 to E 1 to E 0 . During this process, the price level falls, but, in the long run, neither real GDP nor the natural unemployment rate changes.

Visit this website to read about how inflation and unemployment are related.

Fighting Recession or Encouraging Long-Term Growth?

Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs. We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 1953–1972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 1973–1992, productivity growth declined significantly to 1.8% per year. Then, from 1993–2010, productivity growth increased to around 2% per year. In recent years, it has grown less than 2% per year, although it did pick up in 2019 and 2020 to over 2% again. The neoclassical economists believe the underpinnings of long-run productivity growth to be an economy’s investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Government policy should focus on promoting these factors.

Summary of Neoclassical Macroeconomic Policy Recommendations

Let’s summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in “fine-tuning” the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.

Summary of Neoclassical Economics versus Keynesian Economics

Table 26.2 summarizes the key differences between the two schools of thought.

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Transforming Post-Communist Political Economies (1998)

Chapter: 2 rethinking the theory of economic policy: some implications of the new institutionalism, 2 rethinking the theory of economic policy: some implications of the new institutionalism.

Thráinn Eggertsson

INTRODUCTION

The early postwar domination of welfare economics (Samuelson, 1947: Ch. 8; Bergson, 1938), the Keynesian revolution, and the new field of development economics (Kindleberger, 1958) ushered in an age of excessive expectations for the potency of economic policy. To organize their thoughts about the contribution of economics to policy, and confident of their capacity to control social systems, many economists relied on a popular framework, the theory of economic policy (Tinbergen, 1956). In the 1970s, this excessive optimism changed as policy failures and a clearer recognition of the role of private incentives buried naive hopes of fine-tuning the economic system or individual markets (Lucas, 1976; Posner, 1986:Part III). Events also diminished early hopes that development economics would provide strategies for rapid transition in the Third World (Hirschman, 1981). In economics, a new emphasis on information scarcity suggested that transaction costs seriously limit effective social engineering and complicate economic organization (Furubotn and Richter, 1993; Kreps, 1990; Milgrom and Roberts, 1992; North, 1990; Stiglitz, 1994; Williamson, 1985).

Growing pessimism about traditional approaches produced neither systematic reevaluation of development strategies nor a new consensus on the appropriate scope for public policy. Economists offer conflicting explanations of economic successes and failures among Third World countries, while the Eastern European revolution of 1989 took social science unawares when it required guidance for rapid transition to markets. Mainstream economics has lacked a general theory of economic systems and structural change. In recent

years, however, a new theory of institutions based on the economics of property rights and transaction costs has earned a measure of recognition among economists.

Although institutional analysis could potentially complement standard macro- and microeconomic theory in the design of policies for economic development, it has yet to develop a strong policy orientation. 1 This chapter introduces institutional analysis to the old theory of economic policy—to its policy models and its instruments, targets, and policy measures—in the hope that the new institutionalism will reveal its policy implications when viewed against the background of the traditional policy world. More particularly, the chapter explores the ways information scarcity affects policies aimed at social transformation.

The next section briefly summarizes the old theory of economic policy, associated with the Dutch economist Jan Tinbergen (1956). This is followed by an examination of three policy issues that were not a central concern of mainstream economics in the early post-war period: (1) the requirements of structural policy, (2) the need to extend the policy model, and (3) the implications of information scarcity. The chapter then presents a public policy view of the new institutionalism; problems of incomplete data and control and of incomplete models and decisions suggest an intricate policy world. Next is a discussion of the policy determinacy implicit in rational-choice political economy. The final section looks at the general policy implications of institutional analysis for major social transformations, such as those attempted in Eastern Europe and in the Third World.

THE OLD THEORY OF ECONOMIC POLICY

In a perceptive discussion of the theory of economic policy, Hansen ( 1963) emphasizes the central role of models in policy formulation. As almost all policy aims at influencing economic outcomes or processes, policymakers—politicians, administrators, social scientists, voters, or rulers—must rely on a model, or a description of the economic system, which sometimes is little more than a rough qualitative picture (Hansen, 1963:3). It is argued below that the information assumptions of institutional analysis assume that actors employ incomplete and variable models of their environments when attempting to advance their public or private policies.

A formal model of an economic system, such as a firm, a market, or an economy, can be written in the following general way:

In equation (1), x l , … , x n are n endogenous variables, and a 1 , … , a m are m exogenous variables, lagged variables, or parameters, some of which (for instance, exchange rates, tax rates, base money, price ceilings, import restrictions, plan indicators, or agricultural production quotas) are controlled by the policy actor (Hansen, 1963:5). Note a subtle distinction here in the meaning of exogeny. All the exogenous variables in equation (1) are exogenous to the actors of the social system that the model attempts to describe. The policymakers are distinct from the social system and control some of the exogenous variables, whereas other exogenous variables constrain their actions.

The policy model describes the choices open to policymakers: their opportunities to reach targets (desired values of endogenous variables) by applying instruments (exogenous variables they control). Policy targets (goals) are derived from the preferences of policymakers. The structure of the policy model prescribes what target values are attainable and how they are attained. Policy targets may be absolute, or the policymaker may weigh target variables together in a target preference function, T ( x 1 , … , x n ) . 2 Economic policy uses policy instruments either to attain absolute targets or to maximize the target preference function. When targets are fixed (or when target preference functions are maximized without limitations), basic logic suggests two well-known rules of thumb: (1) in general, "the number of instruments should be (at least) equal to the number of targets," and (2) individual instruments should not be assigned to specific targets, but all instruments should be coordinated and directed toward the set of targets (Hansen, 1963:7).

Finally, the structure of the policy model has important implications for policy. It describes the interrelationships among the variables in the model (equation [1]) and determines whether the model can be divided into autonomous departments. Following Simon (1953), all endogenous variables and instruments in a policy model can be arranged according to causal ordering from the first order to the highest, n th, order. Instruments of the n th order influence targets of the nth order without affecting lower orders of the system. However, the use of first-order instruments has repercussions not only for first-order target variables, but also for endogenous variables at higher levels, possibly throughout the system (Hansen, 1963:18-22).

NEW PERSPECTIVES AND THE OLD THEORY

The Tinbergen (1956) framework continues to be an essential part of our mental apparatus. When prescribing policy, economists think, explicitly or implicitly, in terms of instruments and target preference functions, and the notion of a model intervening between preferences and policy remains relevant. A new outlook in social science, however, has weakened economists' belief in their ability to prescribe economic outcomes and mold economic systems. We turn now to three related issues: (1) the requirements of structural policy, (2) the need to extend the policy model, and (3) the implications of information scarcity.

The Requirements of Structural Policy

The old theory of economic policy distinguished quantitative policy from qualitative or structural policy. Quantitative policy takes as given the basic structure of the economic system (or subsystem), i.e., equation (1), and seeks to manipulate existing economic relationships toward some particular end. Until recently, the findings of mainstream economic theory were relevant primarily for quantitative policy, because the theory made few attempts to endogenize or explain (parts of) the economic system. Structural policy, on the other hand, seeks to change the structure of equation (1), and sometimes to add new variables or new relationships. The (immediate) goal is not to achieve a new value for a target variable in the quantitative policy model, but to create a new relationship between (new) instruments and targets.

The discussion in this chapter emphasizes the distinction between quantitative and structural policy, although, as we shall see, the new emphasis on information and incentives has blurred this distinction. Economists have recognized that over time, what were assumed to be quantitative policy initiatives (e.g., rent control, increases in tax rates, or new welfare benefits) have often altered the structure of equation (1). However, it is useful conceptually to distinguish fundamental system transformations from behavioral responses to changes in relative prices within a given system.

Structural policy obviously invites new quantitative policy (and a new quantitative policy model) because the new system must be managed. Furthermore, if the transition to the target structure is slow, appropriate quantitative policy is required to ensure the orderly operation of the system during the transition period (McKinnon, 1991).

Unlike quantitative policy, structural policy cannot be employed effectively without a theory of institutions and institutional change. Policymakers can conserve their mental energy and use relatively simple models, however, as long as low-order instruments can generate spontaneous adjustments in higher-order variables—i.e., in critical institutions—throughout the system. For instance, policymakers would not require complex policy models to guide

the transition to markets in Russia and Eastern Europe if they believed that appropriate market institutions and organizations will emerge autonomously once "prices are set free" (Murrell, 1995). In the final analysis, the structure of the social system is an empirical question, but as a rule of thumb, policymakers in a world of scarce information usually do well to search for powerful low-order instruments.

The Need to Extend the Policy Model

The old theory, which was concerned primarily with quantitative microand macroeconomic relationships, assumed that the target preference functions of policymakers coincide with the normative standards of economic theory. Traditional policy analysis usually ignored the incentives and behavior of political actors or the influence of political processes on targets for growth, stability, pollution abatement, regulation, or the division of investment funds among sectors. Macroeconomics was concerned with stability and growth, while microeconomics focused on allocative efficiency, assuming that policymakers shared these goals.

In recent decades, various scholars have extended the policy model to incorporate endogenous politicians, and analyses of the latter's policies now appear in the literature. Fields such as public choice, political economy, and political macroeconomics attempt to endogenize the choice of targets and instruments, and to provide the elements for a positive theory of structural change (Mueller, 1989; Alt and Shepsle, 1990; Hettich and Winer, 1993; Alesina, 1991).

Pure quantitative economic policy typically (though not always) leaves the political equilibrium intact, particularly when the policy achieves the intended results. In political equilibrium, those in power tend to agree on traditional normative economic goals, such as stability, growth, and allocative efficiency, within the existing institutional framework. 3 Of course, the prevailing institutional framework may leave little or no scope for economic progress. In a relatively stable world, the role of those who control and coordinate key policy instruments is usually well known and clearly established. Generally, there is little doubt about the policy sphere of actors such as the central bank, the finance ministry, the environmental protection agency, or the central planning bureau. Policy analysts have relatively little need for elaborate positive political theory to identify the set of politically sustainable policies. 4

Structural policy, on the other hand, is frequently associated with political instability. Substantial structural measures usually alter the distribution of wealth and power and often emerge in times of political upheaval. The choice of new economic structures frequently involves political disputes and struggles that render the control and coordination of policy instruments uncertain, especially over time. To formulate viable economic policy in an unstable environment and minimize the likelihood of policy reversals, the analyst needs to model interactions among economic, political, and social forces. The need to expand the policy model to incorporate this interaction is particularly obvious when policy experts seek strategies for instituting economic measures that (at least in the short run) have tenuous support among the general public, those in power, and those seeking power. Some policy analysts, for instance, recommended shock treatments or big-bang measures in part because strong measures are likely to overwhelm a disillusioned public and unreliable politicians. They are also more likely to create irreversible structural change (Åslund, 1995). 5

Implications of Information Scarcity

The last decades of the twentieth century have seen increasingly explicit concern with the role of information in social systems and in social science (Coase, 1960; Diamond and Rothschild, 1989; Hirshleifer and Riley, 1979, 1992; Stiglitz, 1994). The very concept of a social system operating with full information staggers the imagination, yet the impression that early postwar neoclassical economics assumed full information is widespread.

A theory of social systems that explicitly models the information environment of its participants confronts three types of information problems: (1) data are scarce, (2) actors economize on scarce information by formulating simplifying models of their environments (as do scientists), and (3) actors have limited capacity to absorb and process data (learn and make decisions). These three issues can be characterized as incomplete data, incomplete models, and incomplete decisions, respectively. The information revolution that has taken place in the social sciences during the last few decades has focused on problems of incomplete data, although the notion of incomplete models and decisions has received some attention. 6 Yet it can be argued that a new theory of economic policy must recognize all three information problems. It must also determine their impact on public policy and the interaction between private and public policy.

The old theory of macroeconomic policy, or rather several scholars in that field, did acknowledge that incomplete data and models can undermine the efforts of policymakers (Hansen, 1963:31-36; Friedman, 1961). In particular, it was argued that various lags of uncertain length can pervert the timing of corrective measures and even turn them into destabilizing impulses. 7 In the 1970s, when macroeconomics acquired formal microfoundations, the theory even attempted to incorporate the interplay between public and private policy models. The early rational expectations school assumed that economic actors would be able to absorb the policy models used by the authorities, thereby enabling the actors to second-guess the authorities' intentions and undertake actions that would undermine economic policy. Random policy measures, however, would not produce this effect (Lucas, 1976). 8

Similarly, the interactions between public and private policy models in individual markets are implicit in the work of Steven N. S. Cheung, who pioneered the economics of contracts (Cheung, 1969). For instance, in his studies of rent control in Hong Kong, Cheung recognized that public policy models were incomplete in that regulators lacked knowledge of how economic actors would establish a new equilibrium in response to official price ceilings in rental markets (Cheung, 1975, 1976). As rent control constrained the price mechanism, the new equilibrium (and private policy) involved various nonprice margins, including the transformation of residential buildings into unregulated warehouses and (premature) demolition and rebuilding. Cheung's empirical work demonstrates, however, that skillful regulators are often able to use trial and error to acquire knowledge about private models, which they may then use to revise the public policy model, design more effective policy measures, avoid unwanted side effects, and eventually come tolerably close to their policy targets.

INSTITUTIONS, INFORMATION, AND CONTROL

We now turn to a discussion of the general implications of the new economics of institutions for the theory of economic policy.

In its initial phase, as is common for new fields of scholarship, the economics of institutions has emphasized explanation, empirical work, and policy analysis—in that order. Most studies, whether examining institutional change or the economic consequences of alternative institutions, are concerned with

the link between institutions and wealth or the social dividend. Therefore, wealth is frequently the (implicit) policy target in these studies. The distribution of power and wealth usually enters into these works as a determinant of economic outcomes or as an important force propelling institutional change.

Incomplete Data and Control

Information and incentives are the driving forces behind theories of social systems that rely on methodological individualism. Institutions are of critical importance for economic performance because they affect both incentives and the cost of information. The economics of institutions derives the structure of the policy model (our equation [1]) from the systems underlying institutions or, in other words, from the rules that, in the language of game theory, affect the expected payoffs of the actors. 9 Therefore, a change in the formal or informal rules that leaves all payoff equations unaffected does not count as institutional change. Institutions emerge from the fusion of social customs and habits; formal rules and regulations; and various enforcement mechanisms, including internalized social norms. The primary weakness of the economics of institutions is its limited understanding of this amalgam of formal and informal rules and their attendant enforcement mechanisms. Most studies ignore social values, while others treat them either as constants or as exogenous variables. 10

In the economics of institutions, the notion of information scarcity usually enters into the analysis through the assumption of incomplete data, but it is the union of incomplete data and what may be called the control problem that gives the new institutionalism its distinctive flavor. 11 Simply stated, costly measurement is responsible for incomplete data. Incomplete data raise the cost of verifying quality and monitoring behavior. This draws attention to one of the central complexities of economic life: commodities and behavior usually have multiple valuable dimensions or margins. Rising marginal cost in acquiring data suggests that actors are usually unable to control fully all margins of the resources over which they have nominal control. Therefore, in-

complete control is a general condition, and, as economics first recognized in the case of open-access fisheries, lack of control generates incentives that can lead actors to dissipate wealth (Barzel, 1989).

The control actors exercise over resources can derive from both external and internal sources: institutions, which represent socially assigned control, are external sources; the various measures actors take themselves, such as monitoring, fencing and locking up valuables, and contracting with other actors, are internal sources. In the literature, the costs of establishing and maintaining control over resources both in exchange and in use are commonly known as transaction costs. High transaction costs act as barriers to productive activities. The policy lesson is clear: structural policy that seeks to increase the capacity of an economic system in order to generate wealth must design institutions that lower transaction costs (North, 1990).

An increase in the social dividend has the potential to benefit all members of a social system, but imperfect institutions (imperfect in terms of the wealth criterion) often persist. To explain imperfect institutions, the new institutionalism typically looks to the political domain and uses high transaction costs in the political process to explain why actors are unable to agree on institutions that would be more conducive to economic growth (Bates, 1990; Moe, 1990; Weingast, 1995). The literature also recognizes that many social institutions and structures that facilitate economic growth emerge spontaneously and not through design. The role of shared social values in economic growth is of particular interest (North, 1990). Scholars in the rational choice tradition have had little success in explaining the emergence and evolution of social values, and it is not clear how policymakers could target social values. Consequently, the role of norms and customs in structural policy is ambiguous. A poor society that attempts to create incentives and information environments for economic growth by launching institutional change can hope for rapid success (1) if its underlying social values are consistent with the new institutions of growth, (2) if social values are malleable and adjust quickly to other aspects of the institutional environment, and (3) if the importance of social values in lowering transaction costs has been overrated. We return to these issues in the final section of the chapter. 12

Incomplete Models and Incomplete Decisions

In a world of scarce information, those who seek to accomplish structural

change must recognize that they are dealing with incomplete, competing models. Although the theory of economic policy has always been stated in terms of policy models, institutional analysis and the information perspective suggest that additional elements are needed:

When attempting to advance their private goals, the subjects of public policy (economic actors, households) rely on private policy models of the physical world, the social system, and the moral order.

Successful structural policy must allow for interactions between public policy models and private models, and revisions to both in response to new data.

An important aspect of public policy is to provide the subjects of policy—actors whose behavior the policymaker seeks to change—with the information needed to revise their private models. This will assist in coordinating models at different levels. 13

When we recognize that revision of models (learning) is often critical for the success of public policy, the revision process itself becomes of great practical interest. Rational-choice social science relies on rules drawn from logic, mathematics, and probability theory, and assumes that social actors use the universal logical rules of science for updating their beliefs or models. Even when this approach treats the origins of private models as exogenous, the assumption that actors use the general rules of science to update their models (for instance, Bayes' rule) implies that the models originate as purely logical or statistical interpretations of available data. In general, the logical approach cannot explain creative and selective interpretation of available data.

For many purposes, however, scholars can use standard logic to explain how actors revise their models and behavior. For instance, in a recent study, Bates and Weingast (1995) investigate revolutionary transformations in Zambia (movement to democracy) and in the former Yugoslavia (eruption of violent communal conflict) in terms of the updating of shared private beliefs (models). Bates and Weingast model interactions among the players as signaling games, where Bayes' rule is used to update models when new data (signals) become available. The paper demonstrates how a policymaker (Milosevic) can bring about a major change in social systems by manipulating signals.

Some scholars question whether actors use standard mathematical logic to update their models. Cognitive psychology and evolutionary biology argue that the human mind relies on ''a large and heterogeneous network of functionally specialized computational devices," rather than functioning as a general-purpose computer (Cosmides and Tooby, 1994:329; Tooby and Cosmides, 1992). A union of evolutionary psychology and economics "might be able to create a science of preferences" (Cosmides and Tooby, 1994:331) and im-

prove our understanding of how actors model their environment, especially the moral order.

In sum, a new theory of structural policy must recognize variable and incomplete models at different levels and allow for interactions between public policy models and private models. In its present state, social science is equipped to do this only on the basis of the general-purpose rational methods of science.

A DIGRESSION ON POLICY DETERMINACY

Rational-choice social science, which assumes that all actors optimize under constraints, implicitly suggests a high degree of policy determinacy. As long as neither social nor political actors were seen as rigorous optimizers, analysts believed there still was considerable scope for reforms. However, when the policy model was expanded to include political and social activity, and optimization under constraints was assumed throughout the social system, the policy choice set seemed to shrink and approach an empty set. This meant that structural policy appeared to have zero degrees of freedom.

The notion of incomplete data, incomplete models, and incomplete decisions changes this picture and expands the policy choice set. The changing fortunes of the Nordic welfare state illustrate this point. Lindbeck (1994, 1995) discusses the ways in which welfare state policies created not only a virtuous circle of benefits, but also an unexpected, undesired, and vicious circle of problems. The problems were associated with delayed changes in the behavior of households, interest groups, public-sector administrators, and politicians. These changes in behavior affected work effort, labor force participation, savings, asset choice, entrepreneurship, and short-term macroeconomic stability, and thereby shrank the tax base of the welfare state.

In analyzing these changes in behavior, Lindbeck recognizes the importance of incomplete data (for instance, delays in obtaining information about new welfare programs), but he puts the greatest weight on what might be called incomplete and variable private policy models. As the welfare system unfolded, the various types of actors, from households to politicians, revised their policy models. Lindbeck (1995) argues that the actors did more than revise their positive models of the social system and adjust their strategies for a new environment; they also revised their models of the moral order and updated their shared social values.

Lindbeck's analysis suggests, therefore, that we need to examine social policies in the Nordic welfare state in terms of incomplete public and private models. At the highest level, public policy models (presumably) did not allow for delayed regime changes in various structural relationships with the system as a whole (for instance, in labor supply or in savings ratios). This policy failure at the top is related to a misreading of private policy models, in particu-

lar a failure to recognize that actors will revise their models, targets, and policies. A revision of private policy models may change not only individual behavior, but also the structure and performance of organizations (households, social networks, firms, public agencies) that are the engine of social action (North, 1990). In Nordic social networks, the interactive revision of private models apparently first lowered the cost (stigma) of being a bona fide welfare recipient, and then the cost of being a welfare chiseler (Lindbeck, 1995).

The notion of policy determinacy, which introduced this section, is an in-house problem in the social sciences and relates to broader ambiguities in the concept of efficiency in the economics of institutions (Furubotn, 1994). A world of incomplete information cannot be determinate: with variable and changing policy models, there is ample scope for new policy directions.

PUBLIC POLICY AND SOCIAL TRANSFORMATIONS

The new institutionalism has paid little attention to the role of policymakers and to the specification of policy instruments for institutional change. With few exceptions, the theory provides only implicit policy lessons. 14 The chapter concludes with a few thoughts about these implicit lessons for major structural transformations.

A General Theory?

Institutional analysis emphasizes that the creation of wealth depends in complex ways on institutions, and argues that institutions are rooted in political and social domains. Social science, however, is fragmented into insular disciplines and offers only partial, and often contentious, insights, rather than a reliable, comprehensive view of social systems. 15

Furthermore, major advances in social science need not provide policymakers with the means to orchestrate major structural changes. Successful transition requires a strategy that will overcome opposition, particularly when the short-term costs of structural adjustment are high, which they frequently will be. In a world of uncertainty, this is a formidable task (Dewatripont and Roland, 1995) . As social science evolves and provides better strategies for institutional change, it is also likely to supply the opponents of change with more sophisticated counter-policies. More knowledge can be a two-edged sword, unless conflict over structural policy involves primarily dispute over the effectiveness of different means to a common end.

Complexity, Learning, and Feedback

The current strength of the new institutionalism (and related fields, such as the new theory of the firm, industrial organization, and positive political economy) lies in partial or sectoral analysis where theory offers various policy insights. The policy implications include (1) methods for containing the control problem and thereby reducing misallocation and the waste of resources, and (2) measures to facilitate the revision of incomplete private and public policy models, thus allowing actors to reach their goals more effectively. The old theory of economic policy explicitly demanded the coordination of a set of policy instruments toward clear-cut goals, but many of the policy insights of institutional analysis are far less specific, particularly concerning the measures needed to restructure actors' information environments.

The literature on property rights, agency theory, asymmetric information, organization, and related topics contains a growing body of theories that examine how to structure control and align incentives with policy goals (Milgrom and Roberts, 1992; McMillan, 1995; Williamson, 1985).

At the macro level, the state contributes to low transaction costs and effective control structures in several ways:

By providing stable standards of measurement in exchange, including stable prices, and generally by creating a solid macroeconomic environment.

By credibly committing to honor ownership rights and avoid using state power to seize resources capriciously, and by following a stable and predictable policy of taxation (Weingast, 1993).

By protecting economic actors from each other through various means, including legal processes, and by facilitating (central) organizations that help establish reputation and detect fraud (Greif et al., 1994).

The extent to which private rules and private enforcement are able to substitute for an effective legal system and provide the necessary foundation for long-term economic growth is an unresolved issue. Recent empirical evidence shows that private actors often invent mechanisms for strengthening

control and lowering transaction costs when they encounter permissive regimes (China) or bureaucratic and inefficient states (Latin America) (McMillan, 1995; Stone et al., 1996). Although these private arrangements often appear to be quite effective, two types of uncertainty surround them: first, private arrangements may create forces that eventually challenge the political status quo, and thus it is uncertain how long permissive or bureaucratic regimes will tolerate unofficial control systems; and second, it is uncertain whether in the long run, private control systems are capable of supporting a modern, integrated national economy.

A final point about the design of control systems concerns the choice between centralization and decentralization. The direct links among measurement costs, incomplete data, and control, combined with the propensity of measurement costs to increase with distance, slant structural policy toward decentralization in structuring both economic organizations and public administration. As a result, concern with the limits of central control is a recurrent theme in the new institutional analysis (Ostrom et al., 1993).

The idea of incomplete and competing models has various implications for policy, although the literature is particularly weak in this area. This outlook weighs against attempts at great experiments or the rapid implementation of structural changes, and suggests modesty, incrementalism, and learning by doing. A new category of instruments emerges in a world of incomplete models: measures for changing the information environment and for creating incentives for actors to revise their models and make them more compatible with policy targets. In a closed society, for instance, policymakers can alter the information environment dramatically by opening the system and facilitating international contacts, such as trade, telecommunications, direct investments, and educational exchanges. Although such measures may have profound implications for structural change, the actual outcome in a dynamic environment is inherently uncertain and generally cannot be modeled in specific terms as a relation between instruments and targets in a Tinbergen policy world.

Various feedback mechanisms are crucial both for coping with incomplete and competing models and for directing outcomes in social processes. Makers of public policy can advance their aims if they are able to design, or facilitate, feedback mechanisms that inform or punish actors who operate with policy models, data, or even goals that are inconsistent with public policy. A properly structured competitive market provides effective feedback in terms of the aggregate wealth criterion. Public policy can push economic enterprises in the direction of more efficiency by fostering various forms of competition and by providing suitable institutions for structuring exit and entry. Empirical evidence from various parts of the world, including China, indicates that not only private firms, but also various hybrid forms of organization will operate relatively efficiently in a competitive environment (McMillan and Naughton, 1996).

The feedback from competition also constrains political units. If the members of agricultural cooperatives operated by local governments can easily exit and join more desirable cooperatives in other localities, poor management is likely to bring corrective feedback and compel local authorities to revise their policy models or targets. Similarly, free entry and exit discipline higher political units, such as the states of a federation, as Weingast (1995) has shown in his work on market-preserving federalism.

Policy Lags and Pathological Path Dependence

With incomplete models, there will be lengthy lags between when a policy is initiated and when relevant actors have the new structures right. During transitions, public and private actors need to experiment for some time once the fundamental incentives are in place before they are able to master the organizations of a modern market economy, including financial organizations, manufacturing firms, apolitical legal systems, and public administration. Few scholars doubted that structural change would involve substantial lags in learning and adjustment, but the institutional literature increasingly refers to far more dramatic lags, which are attributed to increasing returns and path dependence (Arthur, 1994; David, 1994; North, 1990). Several scholars have argued (1) that communities that share specific private policy models (and related informal institutions) resist public policy measures aimed at lowering transaction costs and increasing efficiency, and (2) that these models are extremely durable, enduring sometimes for centuries or even millennia.

In his study of modern reforms in regional administration in Italy, Putnam (1993) explains regional variations in the success of these reforms by variations in social capital and finds the roots of perverse policy models in the twelfth century. For Russia, Hedlund and Sundström (1996:32) trace perverse policy models to the Middle Ages and argue "that the future for Moscow represents a choice between a hierarchy dominated by strong, authoritarian 'organs', or a total breakdown of all organized societal functions."

This strong version of path dependence (which is still controversial) can be compared to the discovery of debilitating genes in specific human groups, and the implications for structural policy are devastating. The new institutionalism does not appear to propose any instruments or measures for manipulating models at this level, which indicates a new type of policy determinacy and calls for more research.

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This ground-breaking new volume focuses on the interaction between political, social, and economic change in Central and Eastern Europe and the New Independent States. It includes a wide selection of analytic papers, thought-provoking essays by leading scholars in diverse fields, and an agenda for future research. It integrates work on the micro and macro levels of the economy and provides a broad overview of the transition process.

This volume broadens the current intellectual and policy debate concerning the historic transition now taking place from a narrow concern with purely economic factors to the dynamics of political and social change. It questions the assumption that the post-communist economies are all following the same path and that they will inevitably develop into replicas of economies in the advanced industrial West. It challenges accepted thinking and promotes the utilization of new methods and perspectives.

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Why Do Governments Intervene?

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The Bottom Line

• Government & Policy

What Impact Does Economics Have on Government Policy?

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Economic conditions often inform the policy changes that governments elect to enact. Specifically in the United States, government policy has always had a large amount of influence on economic growth, the creation of new business entities, and the success of financial markets.

In the broadest sense, a country's economic activity reflects what people, businesses, and governments want to buy and what they want to sell. Because the U.S. has a capitalist economy that relies on the principles of a free market, theoretically, it is primarily the decisions of consumers and producers that mold the economy.

Key Takeaways

• Economic conditions often inform the policy changes that governments elect to enact.
• In the U.S., government policy has always had a large amount of influence on economic growth and the creation of new business entities.
• For those in political power, having a track record of economic growth is often an important consideration (especially if they are in a position of seeking re-election).
• To ensure strong economic growth, there are two main ways that the federal government may respond to economic activity: fiscal policy and monetary policy.
• In the U.S., the Federal Reserve System directs the country's monetary policy.

The government may decide to regulate some aspects of economic activity in order to engineer economic growth or prevent negative economic conditions in the future. In general, a government's active role in responding to and influencing the economic circumstances of a country is for the purpose of preserving and furthering the economic interests of the general public.

For those in political power, having a track record of economic growth is often an important consideration (especially if they are in a position of seeking re-election). In the U.S., many studies have shown that the economy is a major factor that affects how people vote (specifically in the U.S. presidential election). Strong economic growth typically translates to high job creation, stronger wage growth, better financial market performance, and higher corporate profits.

How Do Governments Respond to Economic Activity?

To ensure strong economic growth, there are two main ways that the federal government may respond to economic activity: fiscal policy and monetary policy .

Monetary Policy

One of the most common ways that a government may attempt to influence a country's economic activities is by adjusting the cost of borrowing money. This is most often done by lowering or raising the federal funds rate , a target interest rate that impacts short-term rates on debt such as consumer loans and credit cards. The Federal Reserve increases the federal funds rate to constrict economic growth and decreases the federal funds rate to encourage economic growth.

Another form of monetary policy is the act of the Federal Reserve buying and selling government securities. When the Fed buys a security from a bank, it increases the money supply by injecting funds into that bank. Alternatively, it can sell securities to remove cash and decrease the money supply.

Monetary Policy Example

In response to the COVID-19 pandemic, the Federal Reserve quickly reduced the federal funds rate to 0%. By setting prevailing interest rates very low, the Federal Reserve attempted to support economic activity, maximize employment, and meet price stability goals.

Fiscal Policy

The government may also enact policies that adjust spending, change tax rates, or introduce tax incentives. In regard to government budgets, the government identifies whether or not it wants to spend more money than it anticipates collecting. This process of evaluating public spending aims to promote economic prosperity or cool an overheated economy.

Instead of focusing on how the government spends money, common fiscal policy revolves around how the government collects money. Offering tax incentives, additional tax credits, or lowering tax rates decreases the economic burden on citizens and promotes economic growth. Striking down favorable tax laws or increasing taxes slows economic activity.

Fiscal Policy Example

In response to the COVID-19 pandemic, the Federal government awarded economic impact payments (i.e. stimulus checks) to qualifying Americans. The government directly sent eligible individuals money to promote economic activity and encourage household spending.

Fiscal and monetary policies are both intended to either slow down or ramp up the speed of the economy's rate of growth. This, in turn, can impact the level of prices and the employment rate in the country. However, there are subtle differences between these two types of government action.

Differences Between Government Policies

Change in the money supply or how easy credit is to obtain

Adjustment in federal funds interest rates or money supply

Set by Central Bank

Heavily independent of the political process

Impacts debt industries like housing market

Change in how the existing monetary supply is utilized

Adjustments in government spending and tax rates

Set by Federal Government

Heavily integrated with political process

Impacts government budgets/net deficits

In the U.S., the Federal Reserve System directs the country's monetary policy. The Federal Reserve System—also called "the Fed"—is the central bank of the United States. Established in 1913 by Congress, the Fed controls the money supply and actively uses policy to respond to and influence economic conditions.

The Fed adjusts the interest rate that banks charge to borrow from one another. (This cost is then passed onto consumers.) The Fed may lower the interest rate to keep borrowing cheap, ensure that credit is widely available, and boost consumer (and business) confidence. Conversely, the Fed may decide to raise interest rates in a strong economy, or in response to inflation concerns—the increase in prices that occurs when people have more to spend than what's available to buy.

In the two ways governments can intervene in the economy, you'll note that monetary policy is set by the Federal Reserve, an independent entity technically not part of the Federal government. On the other hand, fiscal policy requires political intervention and majority approval (for items not issued by executive order by the President).

Achieving Financial Stability in the U.S. Economy

Prior to the creation of the Fed in 1913, the U.S. had experienced several severe economic disruptions as a result of massive bank failures and business bankruptcies. As an institution, the Fed was tasked with ensuring financial stability in the U.S. economy.

After the Great Depression , the greatest threat to the stability of the U.S. economy was recessionary periods: periods of slow economic growth and high unemployment rates. In combination, these two factors created a sustained period of decline in the gross domestic product (GDP). In response to this, the government increased its own spending, cut taxes (in order to encourage consumers to spend more), and increased the money supply (which also encouraged more spending).

Beginning in the 1970s, a different economic reality emerged. This expansionary economy with substantial money supply growth led to a sustained period of a high level of inflation. In response to these economic factors, the U.S. government started focusing less on combating recession and more on controlling inflation. Thus, the government enacted policies that limited government spending, reduced tax cuts, and limited growth in the money supply.

At this time, the government also shifted away from its reliance on fiscal policy—the manipulation of government revenues to influence the economy. The fiscal policy did not prove effective at addressing high levels of inflation, high levels of unemployment , and vast government deficits. Instead, the government turned to monetary policy—controlling the nation's money supply through such devices as interest rates—in order to regulate the overall pace of economic activity.

Since the 1970s, the two main goals of the Fed have been to achieve maximum employment in the U.S. and to maintain a stable inflation rate. This dual mandate is difficult to achieve; by combating one of the goals, it becomes more difficult to fight the other.

While outside events may influence economic activity, governments use economic means to enact changes as they see fit. This may include changes to tax policy, adjustments to the federal funds rate, fluctuations in the money supply, or alternations to government spending.

Should the Government Intervene in the Economy?

Whether or not the government should intervene in the economy is a deeply-rooted philosophical question. Some believe it is the government's responsibility to protect its citizens from economic hardship. Others believe the natural course of free markets and free trade will self-regulate as it is supposed to.

Why Might the Government Intervene in the Economy?

The government has an inherent interest in protecting the well-being of its citizens. Due to prevailing conditions in the world, the government might see fit to enact certain legislation to preserve the quality of life for its citizens. The government might also enact legislation to promote economic well-being and equity across different socioeconomic classes.

What Are Some Ways the Government Intervenes in the Economy?

The government has two primary ways of interacting with the economy. Through monetary policy, the government controls prevailing interest rates and makes obtaining debt easier or harder. Through fiscal policy, the government controls spending levels and how to allocate resources.

Keynesian economic theory holds that governments should hold their citizens out of a recession. Governments do this by enacting monetary and fiscal policies. By having a central bank (i.e. the Federal Reserve), the United States has the ability to manipulate economic policy in an attempt to intervene when appropriate.

U.S. Department of State. " U.S. 2022 Midterm Elections: Role of the Economy in Elections ."

Sage Publications. " Economic Perceptions and Voting Behavior in US Presidential Elections ."

Federal Reserve Board. " Monetary Policy Principles and Practice ."

Federal Reserve Board. " Federal Reserve issues FOMC statement, March 15, 2020 ."

Internal Revenue Service. " Economic Impact Payments: What You Need to Know ."

Federal Reserve Board. " What Is the Purpose of the Federal Reserve System? "

Federal Reserve History. " The Great Inflation ."

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Economic methodology for policy guidance

How economics should be done, by david colander and huei-chun su, edward elgar, 2018, $40.00, pp 270+ xxvi, cheltenham uk, isbn 978-178897992-4; where economics went wrong, by david colander and craig freedman, princeton university press, 2019, $27.95, pp 267 + xii, princeton nj, isbn 978-0-691-17920-9.

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Before reading two recent books of which David Colander is first author, I had thought of him as a unique gadfly who has been the best promoter of three loosely connected strands of work. He has done insider-informed sociology of economic ideas that is happily unencumbered by ponderous sociological theory. He has empirically studied, and kept the profession well briefed on, patterns in the professional and intellectual formation and attitudes of apprentice economists. And he has promoted the application of complexity theory in macroeconomics. Now, thanks to these new books, I appreciate that these three activities are unified by a distinctive methodological perspective, and that, importantly, my description of the third strand above isn’t quite accurate. Henceforth I’ll say: Colander is the best example of an economic methodologist who seriously aims to help economists increase the effectiveness of their influence on society and policy. What I mean by ‘best’ here is that he is the one most likely to actually enjoy some success in this ambition. This is for two main reasons. First, he is sympathetic to the aims that most economists actually have, instead of wishing they would try to do something else. Second, he does not ask economists to think with imported concepts they would have to struggle to integrate into their standard thinking kit.

Though unified in their themes and implications, the two books are very different from one another, and, for reasons I will explain, in their sophistication and depth. The Colander and Su volume is a collection of Colander’s papers, some co-authored, published in various journals and collections between 1987 and 2016. Su curated them into topic clusters and provides an introduction that ties them together. None of the older essays have become out-dated, which partly reflects how little other methodological literature has addressed Colander’s issues of concern. The Colander and Freedman book is a sketch of one strand of the history of what they regard as a major mis-step in the evolution of economic method, the same mis-step that is the recurrent focus of attention in the essays in Colander and Su. As I will explain later, the historical strand in question presents the reader with a distractingly oblique view of the main problem. I will argue that it might lead readers who do not acquaint themselves with the much broader vision presented in the Elgar volume to underestimate the significance and scope of Colander’s critique. There are likely to be many such readers, because the Princeton volume is shorter, written in simple, non-technical language, and distributed by a publisher with wider reach than Elgar. I likely would have had a somewhat negative view of it had I not read the Colander and Su collection first.

I will focus first on the deeper book. Colander’s core methodological thesis is stated clearly in Su’s introduction, and re-stated in several of the papers in the collection. This reiteration is useful, serving to make clear what is foundational and what is derived in Colander’s portfolio of opinions. So I will summarise the foundation.

According to Colander, economic science seeks to discover universal, or at least highly persistent and pervasive, relationships among economic states and processes. It does this by means of mathematical modelling. For optimal progress, the more sophisticated the math the better, and so theoretical economists should be students of new developments in mathematics – and also, for the sake of econometrics, in statistics. But because of its universalistic ambitions and mathematical method, economic science is necessarily highly abstract. This equips it poorly as a tool for generating policy advice, because policies are always implemented under special local circumstances in which major causal effects are generated by (i) infrequent contingencies and correlations amongst economic variables themselves, (ii) exogenous political, social, cultural, geographic, demographic, technological, and institutional peculiarities that resist specification and identification of tight priors, and (iii) strategic feedback from agents with imperfect knowledge, heterogeneous utility functions, and limited information-processing resources, especially time. Policy is typically centrally concerned with active short-run coordination, in time and space, of choices that do not need such deliberate management in the long-run modelled by abstract theory. To give an example of my own: quantitative easing (QE) by central banks after 2008 should have no effect on asset values in the long run because sophisticated traders who can use derivatives to spread risk across the time horizon are at least as capable of forecasting bond yields as the monetary authorities, and have the informational advantage of knowing their own coefficients of intertemporal risk aversion. But QE, first in the US and a few years later in the EU, probably twice prevented a world depression because most actual businesses cannot survive temporary demand crashes or credit stops on the basis of expected future liquidity.

Colander’s heroes in the history of economic methodology, who are called ‘Classical’ in Colander and Su and ‘Classical Liberal’ in Colander and Freedman (about which more later) knew that economic science is not designed to directly yield policy advice. They resisted the ‘vice’ of the errant outlier in their own ranks, Ricardo. A bit awkwardly for Colander’s history, two of the heroes, J.S. Mill and Nassau Senior, failed to follow their own advice when they took real-time positions on responses to the Irish famine. It is true, however, that Mill recognised, at least when he was philosophising instead of trying to improve the work ethics of the Irish, the limited practical power of abstract theory. And Colander’s most regularly quoted wise man, John Neville Keynes, was explicit that economic policy formation is an ‘art’, meaning that its success depends on discerning ethical and political judgment and accumulated weight of experience, rather than a ‘science’ in the sense of boiling down to mathematical generalisations that can be relied upon regardless of circumstances. Keynes’s son, the most influential producer of policies among economists after Smith and Marx, was equally trenchant and more rhetorically inventive in stressing the same point. In this clarity, Keynes the younger also benefited from the influence of his teacher Marshall, who favoured modelling ‘one thing at a time’ to general equilibrium reasoning because, to actual business strategists, the former is a sensible choice input and the latter isn’t. Colander’s final frequently quoted advocate of a firewall between economic science and the art of economic policy guidance is Lionel Robbins.

What disrupted this sound picture, according to Colander, was the rise of technical welfare economics and the emphasis on optimal control specification. This body of theory directly drew foundations for normative economics from general equilibrium theory. Colander emphasises that the hubris incorporated in and encouraged by this ambition was smelled out quite quickly by economists themselves. He approvingly cites Graaff’s ( Citation 1957 ) conclusion, at the end of his elegant consolidation of formal welfare theory, that the ‘possibility of building a useful and interesting theory of welfare economics … is exceedingly small’ (p. 169). Over the six decades since Graaff’s book, economists have tolerated a kind of institutional schizophrenia about welfare theory. On the one hand, endorsement of sentiments such as Graaff’s have been widespread and frequent, and on occasions the sub-field has been pronounced ‘dead’ (on grounds critically reviewed by Fleurbaey & Mongin, Citation 2005 ). On the other hand, the core theory has been continuously retrofitted and refined within the many branches of applied policy economics, such as international trade theory, development, transport, health, and labour economics. Defense of this state of affairs typically appeals to pragmatism: policy choices must be made, and if they are not to be driven by ideologies, then even flawed economic theory is surely a better basis than nothing. As Colander and many others have noted, this somewhat forlorn justification is not consistent with the levels of confidence with which economists typically offer normative advice.

Colander points out that what is meant by ‘advice’ here itself needs scrutiny. As Sugden ( Citation 2018 ) has also recently argued, the ‘policy recommendations’ sections dutifully constructed near the ends of journal articles are seldom addressed to actual agents who commissioned the advice, or who could possibly implement it. I will give an example from my immediate professional experience in developing economically sound prioritisation of the South African roads budget (Ross & Townshend, Citation 2021 ). Most work on this topic by other economists has aimed to identify the optimal proportions of national investment and expenditure for roads. I have no evidence that this work has had any influence on policy choice, because in South Africa as in all democracies there is no agent who has discretion to allocate the national budget on the basis of effects on the national economy conceived through general equilibrium representation. Budgets result from political horse trading shaped by the relative power of cabinet departments and interest group lobbies. Actual decision makers, roads authorities at various administrative levels, have occasionally sought and used economists’ advice on how to invest the budgets they’re given, and there is currently a nascent attempt underway to generalise such local-level consultation by Townshend and me, under the coordinating guidance of the National Roads Agency. Crucially, this effort is premised on the fact that our models are not abstract, but take account of relationships between idiosyncratic local conditions and types of pavement surfaces at a granular scale, i.e. discriminating not just between sealed or gravel, but among 11 different seals. Our task is to prioritise roads for resealing, constrained by a set of policy targets. Colander refers to this sort of role for the economist as ‘general contracting’. It does not involve neglect of economic theory. If it did, why would an economist be consulted in the first place? But theory is used for building checklists of economic relations to be studied, and for identifying opportunity costs and variables that accountants and engineers aren’t trained to estimate, such as local shadow prices of unskilled labour for maintenance of such surfaces as don’t require high-tech methods.

Among recent commentators on methodology, this theme is not unique to Colander and his co-authors. Eight decades ago J.M. Keynes ( Citation 1936 ) urged economists to refrain from promoting sweeping normative programmes and to adopt the posture of ‘humble, competent people, on a level with dentists’ (p. 373). Leamer ( Citation 2012 ) argues that because economists’ collective allocation of effort to problems has its primary source in policy challenges, economics is a ‘craft’ rather than a ‘science’. His main focus of attention is on how the Heckscher-Ohlin (H–O) family of international trade models, which clearly does not literally describe actual trade flows between any countries, can be used in assessing prospective trade agreements for risks of Stolper-Samuelson effects on domestic wages. This depends, Leamer argues, on the economist’s crafty judgment, honed from experience, about the H–O model’s pragmatic diagnostics, as well as about effect sizes that cannot be econometrically estimated on the basis of a model that isn’t ‘true’. Finally Duflo ( Citation 2017 ) sketches a role for development economists as ‘plumbers’. By this she refers to the value of attention to local-scale features that accommodate or resist installation of a policy, as opposed to just its intended inputs and desired outputs. This plumbing role corresponds particularly closely to Colander’s ‘general contracting’. However, Duflo does not follow Colander – or Keynes – in urging humbleness upon economists, because she thinks that while some economists engage in plumbing, other economists (‘engineers’) should be entrusted with formal mechanism design and still others (‘scientists’) should develop and test relevant generalisations. Duflo’s conception of economic science emphasises a specific form of model-free experimentation. As with other promoters of randomised control trials who think that this methodology is recommended because it ‘lets the data speak’, she attributes less value to structural economic theory than Colander does. Thus full positioning of the ‘randomistas’ within Colander’s critical framework is complicated, and warrants special attention elsewhere.

I turn now to another topic that looms large in the volumes under review, special problems around macroeconomics. Colander and his co-authors share the widespread disenchantment with macroeconomics that accords dynamic stochastic general equilibrium (DSGE) the status of core model. The strongest arguments for dethroning it echo Romer’s ( Citation 2016 ) critique, which is cited several times in the more recent of the papers in Colander and Su. The main sources of rot in DSGE according to Romer are that it stuffs what matters most to macroeconomic causality into the black box of ‘exogenous shocks’ (see Leamer and Shinde [ Citation 2021 ] for a more extended discussion of this general problem), and relies for apparent empirical sensitivity on ultimately spurious ‘calibration’ procedures. Citations to Romer notwithstanding, however, Colander mainly quarrels with DSGE-based macro as a specific example of his more general target, overly abstract modelling used to directly derive policy selection. DSGE is particularly vulnerable to this attack because, unlike avowedly foundational theories such as Arrow-Debreu GE, the intended point of DSGE is to isolate effects of variables that can be manipulated by monetary policy authorities. The strongest available defenses of DSGE concede this point. The basic DSGE model is invariably customised to reflect country-specific factors and histories by central banks that use it for forecasting and guidance, notwithstanding the obvious consequent risk of over-fitting. By similar logic, DSGE modellers have responded to the failure of most macroeconomists to anticipate the 2008 financial crisis by bolting effects of financial fluctuations onto the core model that assigns no role to money. This response can be defended against charges of being ad hoc precisely by emphasising the status of macroeconomics as a form of policy engineering rather than disinterested science. Arguably, prior to the Great Recession central banks saw their objective as being largely restricted to control of inflation. Within this restriction, what macroeconomic models were asked to forecast were rates of medium-term growth and ratios of aggregate investment to aggregate savings and aggregate consumption. A case can be made, based on trends measured before the COVID-19 singularity, that they were doing this successfully even in 2007. (Of course, these variables moved far from their trend lines in the short run, prior to recovery after 2011.) Then, the defense continues, central banks extended their mandates into fiscal policy by engaging in quantitative easing; so the scope of DSGE-based modelling was likewise extended to incorporate traditional fiscal policy variables. Thus modelling choices followed derived demand for policy advice. Whether someone finds this response persuasive or not, its logic positively embraces the kind of direct theory to policy relationship that Colander attacks.

Colander and co-authors don’t engage with these sorts of details on how DSGE modelling is institutionally implemented. They implicitly assume that the policy goal of all macroeconomics must be reducing business cycle amplitude. Of course this assumption is fully warranted where the origins of macroeconomics are concerned, and Colander’s astute paper on the nature of economists’ contribution to pre-2008 policy and forecasting failure, which is among the best chapters in Colander and Su, takes a long historical approach. However, when Colander goes on in the next chapter to promote cointegrated vector auto regression (CVAR) as a superior and distinctively ‘European’ alternative to DSGE, the absence of attention, at least within the covers of the book, to the details of DSGE-inspired policy guidance leaves him vulnerable to the following line of argument. Overly general DSGE models, without situational bolt-ons and incorporating maximum-strength rational expectations, are indeed inferior to carefully constructed CVAR modelling as policy tools. Arguably, however, ‘standard’ CVAR models have been insufficiently sensitive to modest interpretations of rational expectations of the kind discussed by Ragot ( Citation 2012 ). Colander complains that European macroeconomists have been failing to adequately hold their line and have shown increasing signs of surrendering to the hegemony of DSGE. But as applied DSGE modellers abandon purity and bolt on financial and contextual sidecars, they effectively converge their approach with those CVAR modellers who recognise that the Lucas critique may be over-stated but should not be ignored. There is tension in praising CVAR for its flexibility, on the one hand, and worrying that its ‘true spirit’ is being diluted, on the other hand.

I referred in opening this review to my somewhat mistaken prior image of Colander as an advocate of applying complexity theory in economics. There are many such advocates (e.g. Albin, Citation 1998 ; Anderson et al., Citation 1988 ; Arthur et al., Citation 1997 ; Blume & Durlauf, Citation 2006 ; Ormerod, Citation 1998 ), and few mainstream economists regard their contributions as fringe heterodoxy. (Arrow’s presence among the complexity advocates would make such dismissal implausible all by itself.) However, as Colander acknowledges, their impact on economic theory and on policy has been slight. Many commentators explain this with rhetoric about ‘early days’ of a new technology. But the earliest source I cited above was published thirty-three years ago. Colander emphasises a different view, grounded in his general methodological critique. Economics based on complexity theory is still theory , and as such should not be directly applied to policy. One might think that a complex-systems model of an economic process is closer to the context-sensitive level where Colander thinks that normative economists should live if it is based on simulation of that specific process and either incorporates or represents its institutional idiosyncrasies. But this is not always or necessarily true – standard applied economics abounds with country-specific and firm-specific models – and Colander does not lay much stress on the point. What he more interestingly argues is that it is the economy itself that is complex, in the sense of being dynamical and non-ergodic, and this interferes with the direct applicability of any theory, including theory about complex systems, for normative guidance. Of course Colander believes that models which themselves include dynamics and avoid assuming ergodicity are likely to better fit data, all else being equal, than models that don’t. So he is strongly sympathetic to increased investment, especially by younger economists, in complexity-based economic theory and in multi-agent modelling that breaks as radically as possible with representative agent restrictions. But he also recognises the validity in objections that generality is among the aims of good theory, whereas methodology based on simulation struggles to achieve this. Colander’s advocacy of a strong ‘firewall’ (his recurrent phrase) between theoretical and artful economics forms a barrier in both directions, thus blocking simple and sweeping inferences such as ‘good policy for a complex system should best be informed by theoretical models that are themselves complex’. On the other hand, it is hard to argue with the idea that if the macroeconomy is complex and dynamical then a model that doesn’t represent the complexity and permits only comparative-statics analysis is likely to miss important patterns, no matter how clever and innovative the econometric compensations.

My own opinion is that economists should study complex-systems models as a search method for finding potentially interesting patterns, but should not base forecasts on them in advance of having much better confidence than is currently warranted about which elements that could be simulated are most informative, conditional on identified structural variables such as relative elasticities in factor markets. Colander might, for all I can tell, agree with this, subject to the caveat that we should not use theory alone to generate forecasts for policy guidance in the first place. And I think he is right about that, his central point. Where macroeconomics is concerned, I came to Colander and Su already persuaded of their conclusion by the example of Leamer ( Citation 2009 ), the most satisfying book on macroeconomic policy I know.

I said at the outset that the Colander and Freedman volume is a less nutritious intellectual meal than Colander and Su, and furthermore that I would advise no student to read Colander and Freedman unless they’d read Colander and Su first. I’ll now explain these judgments.

Colander and Freedman is a historical narrative intended to explain, in part, why and how economists forgot the good advice of Mill, Marshall, Robbins, and the two Keyneses. Its greatest value lies in the fact that it is based partly on interviews with participants in key debates. Annoyingly, there is no list of these interviewees, but based on the text they at least included Gary Becker, Ronald Coase, Aaron Director, Milton Friedman, Rose Friedman, James Kindahl, Sherwin Rosen, and Paul Samuelson. Of course, given the timelines of these individuals, most of the interviews occurred some years ago. The reader will note the dominance of Chicago economists in this list, and that reflects the primary conceit of the narrative, which may strike many readers as eccentric.

Here is the story plot, with apologies to Colander and Freedman for the inevitability of making it look less nuanced and informative than it really is by boiling it down to bare bones. The play has three main acts.

In Act I, at the dawn of the post-war world, leading economic theorists inherited a dominant tradition with two features: it had been ‘Classical Liberal’ and it had been skeptical about deriving policy from technical analysis, and especially from mathematical analysis (as opposed to insight from diagrams and technical stories). Colander and Freedman’s point in referring to their heroes gallery, the same wise historical methodologists who are honoured throughout Colander and Su, as ‘Classical Liberals’ is that although they did not deny that governments should play active roles in fostering and maintaining civil society, they thought that social efficiency was generally best served by letting markets allocate most resources based on price signals. As Marshall argued explicitly, a greater burden of argument rests with a proponent of a new public intervention to regulate commerce. So they were economic liberals.

Act II stars Samuelson. After both theoretical and policy anticipations in the 1930s, the Classical Liberalism of Act I came under pressure as theorists, primarily those associated with the Cowles Commission and leading East Coast schools, especially Harvard and MIT, developed the technical economics of optimal control. This involved stapling together, though without genuine connecting foundations, the model of a boundlessly rational agent (an individual, a firm, or a household) with Hicksian (IS/LM) macroeconomics. The great Arrow-Debreu result was viewed as confirmation of the efficiency of markets, but in principle efficient general equilibrium allocations could be brought about by a planner with power to effect lump-sum transfers at least as well as by independent participants coordinated only by prices. The logic of control implied direct determination of policy from theory; and because the content of the theory in question had to be precise, all proposed elements of it had to be represented mathematically. An implication was that makers of economic policy should have no room in their toolkits for imprecise concepts from qualitative social theories or everyday politics and culture.

In Act III the Economics Department at Chicago, following a period of ambivalence in the immediate postwar years, acquired a distinctive intellectual mission under the leadership of Director, Stigler, and Friedman to be the bastion of resistance against ‘Saltwater’ indifference to the avowedly essential role of free markets in promoting efficiency and prosperity. Colander and Freedman argue that the Chicago School might have – and should have – stemmed the tide by preserving the Classical Liberalism exemplified by their leader in the previous generation, Frank Knight. Indeed, Colander and Freedman further maintain, they could have reinvigorated Classical Liberalism in a distinctive way had they brought Buchanan’s understanding of public choice, and especially Coase’s view of transaction costs as unavoidable barriers to general equilibrium reasoning as a policy recipe, into their tent. But none of these things happened. Buchanan’s recognition that government officials are agents within the economy rather than its external choreographers was latched, under Tullock’s influence, to axiomatic rational choice theory. Coase’s insight was turned upside down by Stigler and marketed to economists as Coase’s Theorem, stating that where transaction costs are removed, as they are in general equilibrium, market regulation is pointless since agents will bargain to efficiency. Most importantly, Friedman ( Citation 1953 ) in the most influential methodological essay of the postwar era, argued that apparent policy disagreements among economists mainly stemmed from confusions about the role of counterfactual assumptions in economic theory, and that if this mistake was avoided then the content of economics could consist entirely of a positive science of efficiency. According to Chicago, the central message of that science for policy makers is that they should protect legal property entitlements and otherwise leave almost all other domestic policy questions to be settled by market dynamics. One could of course fill a decent-sized library with criticism of this libertarian (or ‘neo-liberal’) mantra. Colander and Freedman’s fire is directed instead at the methodological context in which Friedman and his colleagues grounded its defense: the view that economic science can be used to directly resolve policy controversies.

Colander and Freedman don’t explain why they chose to defend their Classical Liberal view by focusing on those who they think should have saved it from eclipse, the Chicago gang, rather than on those who played the principal role in displacing it to begin with, the ‘saltwater’ economists of optimal control. (Compare, by contrast, a recent book that has much in common with Colander and Freedman’s critique, but which I found more enlightening, Mirowski and Nik-Khah [ Citation 2017 ].) One possible reason is that it was indeed Friedman, not Samuelson (and certainly not Arrow), who went to the trouble of explicitly arguing, in exact contraposition to Colander and Freedman’s central thesis, that normative policy disagreements can and should be directly resolved by appeal to results from positive economic theory. But then the reader might reasonably want to know from the historians what Samuelson, Arrow, Baumol, Phelps, and other more representative voices on methodology thought about Friedman’s, Citation 1953 essay. Colander and Freedman’s subtitle is Where Economics Went Wrong . If the literal intended reference of this phrase is to Chicago, this suggests acceptance of that School’s conceit that it represented the main core of the discipline. The Chicago economists were remarkable advertisers, and managed to convince much of the policy establishment that their views were the default principles of mainstream economists. But this was never true.

In this context it is also worth remembering that the majority of person hours that academic economists (as opposed to non-academic economists working for financial companies or governments or public agencies) devote to policy consulting are microeconomists’ hours. Much of this consulting builds real, functioning mechanisms. I am thinking here of unbiquitous features of the fixed economic environment such as dynamic pricing algorithms, public asset and service auctions, tax compliance incentives, matching algorithms, and public health queuing rules. The majority of this work is applied game theory. When Colander and Freedman occasionally mention game-theoretic modelling – for example, in their invocation of Ariel Rubinstein and Alvin Roth as contemporary expressers of the Classical Liberal ethos – they suggest that it avoids their central criticism. As reference to Rubinstein and Roth suggests, Colander and Freedman also seem to exclude experimental economists from inclusion among those who have ‘gone wrong’. In my experience, experimental labs tend far more to derive the problems that inspire their designs from policy challenges than from abstract theory. And what about mechanism designers? What about Duflo’s ‘plumbers’? Coyle ( Citation 2007 ) devotes most of her book on the contemporary ‘soul of economics’ to these activities. In general, it seems that where Colander and his co-authors talk about ‘economics’ gone adrift, they really mean: applied general-equilibrium economics and macroeconomics.

I have concentrated on criticisms. This should not obscure the point that the Colander and Su volume is enlightening and engrossing, is for the most part persuasive and sensible, and is richer than the sum of its parts. Colander and Freedman is a useful though somewhat slight extension to the historical dimension of Colander’s critique.

I have long thought that economic methodologists and philosophers of economics have neglected the consulting side – consulting under real commissions, that is – of the profession. Closer attention to this would allow us to give more closely informed answers to questions that Colander and his co-authors raise. How does use of theoretical models vary when one passes from client-directed to open-ended policy framing? To what extent does consulting experience reflect back into economists’ more curiosity-driven modelling? As far as I know these things haven’t been examined. It is a mark of methodological reflection far from the herd, such as Colander’s, that new matters for investigation come into focus.

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