Economic theory and policy failure

Recently, we have seen repeated, massive failures of major policies focused on economic issues. For example, recent development policies advocated for countries in South America and Africa, the policies promoted by Western advisors during the conversion of the Soviet economies from communist to market-oriented, and the regulatory and risk management policies responsible for the still unfolding world-wide credit imbroglio.

These policy failures have imposed immense suffering, excess death, and social and economic costs on their target populations. Furthermore, all of these policies were promoted as dictated by economic theory—and promoted not only by political snake oil salesmen, but by cadres of distinguished economic experts. Economic theory probably contributed significantly to the adoption of these policies by supporting passionate intensity, convincing rhetoric and intimidating mathematics. Complete lack of a theory for analyzing these policies, while far from ideal, would probably have saved many lives and much treasure.

What was wrong? Economic theory in these cases actively suppressed consideration of institutional dynamics.

These were not special cases. Classical economic theory is pervasively hostile to institutional dynamics:

  • It assumes a constant (and adequate) institutional backdrop. It assumes that transactions settle, contracts are enforced, theft is more costly than honest purchase, etc. It assumes this backdrop is not subject to manipulation by the market participants. Thus institutional dynamics are simply impossible in classical economic models.
  • It assumes transactions are evaluated in terms of one or a few scalar values — money, “utility”, etc. Basing all decisions on a scalar metric eliminates any “fine structure”, and participants in real transactions depend on this “fine structure” to negotiate their expectations. As a result, theoretical economic transactions lack any means to engage with institutional dynamics, although real economic transactions, of course, play a major role in institutional dynamics.

These moves are justified as “idealizations” that make economic models tractable. However as with metaphors, idealizations must fit the task at hand or they are worse than useless. The policy failures mentioned above, as well as a wide range of other examples, indicate that the idealizations of classical economic theory are a very bad fit to many of the social policy tasks where economic models are typically invoked as justifications.

Specifically, the effects of most public policy decisions depend critically on institutional issues — the institutions that will implement them, the institutions they will strengthen or weaken, and usually the institutional changes they will cause, intentionally or unintentionally.

Economics aspires to judge the implications of a wide range of public policy proposals. But because it clings to a theoretical framework that idealizes away institutional dynamics, it actually cannot address critical aspects of any policy that is substantially affected by institutional issues—and that is most policies. Worse, economic models tend to distract from or entirely suppress deep analysis of institutional dynamics, so they actively damage policy discussions.

One possible option for those who wish to preserve classical economic theory would be to restrict its application to cases where its idealizations do fit well enough to be useful. Certainly there are such cases. To exclude such domains as our modern financial systems from the purview of economic theory seems perverse, yet this would be an inevitable consequence of limiting current theory to domains where it works “well enough”.

In practice institutional issues can’t be ignored in the vast majority of policy decisions. As a result, policy discussion tend to be defined in terms of economic “stories” about policy effects that are not theoretically valid, but that gain credence by invoking the impressive theoretical framework of classical economics. Actual arguments for or against a policy then resort to ad hoc models of institutional dynamics, retrofitted rhetorically and pragmatically to these economic “stories”. The dominance of the economic “story” obscures the ad hoc nature of the argument, avoids deep engagement with the models of institutional dynamics, and keeps the institutional analysis shallow and weak.

Rhetorically effective but obviously mendacious examples of this are the policy arguments for “supply side economics”, school vouchers, increased “personal responsibility” in medical care, and unrestricted free trade. The arguments that led to disasters in recent development policy and financial market policy are more sophisticated but equally hollow.
As mentioned above, the absence of a dominant theory would be less harmful in these cases than current use of economic theory. Unfortunately even the worst theories can only be displaced by other theories, so simply expelling classical economics from policy debates is not realistic. On the other hand, if we can find a theory that allows us to integrate and give proper weight to pragmatic arguments about institutional dynamics, and helps us develop stronger models as we go forward, then we have a reasonable chance to improve policy discussion.

Happily, finding a theory that allows for institutional dynamics and still can match classical economics in its areas of strength is a realistic goal. We now have theoretical resources that allow us to subsume the results of classical economics models, and that can also be gracefully extended to model institutional dynamics. This is a strong claim, but it is justified by examples like Duncan Foley’s work in economics, and H. Peyton Young’s work in institutional dynamics.

Long time no see

I hope to be around more often, at least for a while.