The Imperative of Understanding the Role of Institutions, Culture, and History in Economics

I recently read an article by Dr. Avner Greif of Stanford University titled, “Cultural Beliefs and the Organization of Society: A Historical and Theoretical Reflection on Collectivist and individualist Societies.” While it is a somewhat dated article being published in 1994 (see citation below), Dr. Greif’s conclusion struck me as being very important and still applicable to understanding economic development and economics in general today. I think his concluding remarks are also important to take into consideration when one is attempting to apply economics in the making of public policy or just trying to understand a certain issue or event.

Here are the highlights I took from Dr. Greif’s conclusion.

…This paper points to factors that make trajectories of societal organization – and hence economic growth – path dependent. Given the technologically determined rules of the game, institutions – the nontechnological constraints on human interactions – are composed of two interrelated elements: cultural beliefs (how individuals expect others to act in various contingencies) and organizations (the endogenous human constructs that alter the rules of the game…). Thus the capacity of societal organizations to change is a function of its history, since institutions are combined of organizations and cultural beliefs, cultural beliefs are uncoordinated expectations, organizations reinforce the cultural beliefs that led to their adoption, and past organizations and cultural beliefs influence historically subsequent games, organizations, and equilibria.

Understanding the sources of institutional path dependence indicates the factors that forestall successful intersociety adoption of institutions for which there are many historical and contemporary examples…The view of institutions developed in this paper indicates why it is misleading to expect that a beneficial organization of one society will yield the same results in another. The effect of organizations is a function of their impact on the rules of the game and the cultural beliefs of the society within which this game is embedded. Analyzing economic and political institutions and the impact of organizational modifications requires the examination of the historical development and implications of the related cultural beliefs.

Past, present, and future economic growth is not a mere function of endowment, technology, and preferences. It is a complex process in which the organization of society plays a significant role. The organization of society itself, however, reflects historical, cultural, social, political, and economic processes. Comparative historical analysis is likely to enhance our comprehension of the evolution of diverse societal organization, since this process is historical in nature. Furthermore, such an analysis provides the historical perspective and diversity required to examine institutional evolution and the interrelations between culture, the organization of society, and economic growth (Greif 1994, 943-944).

What this means to me is that if we are truly going to understand economics, the process of economic development, and the functioning of economies, we have to also understand the related historical, political, social, cultural, and institutional elements. We can’t only rely on mainstream economic theory. The culture and institutions that are embedded within an economic system are vitally important to fully understanding how that economy functions at a macro level, as well as gaining a full understanding of the economic behavior at the micro level.

Furthermore, since history (along with culture) plays a key role in determining the path dependence of the economy’s institutions, it is imperative to understand the historical context of an economy in order to be able to appropriately apply economic theory to the development and implementation of effective policy. Institutions, culture, and history matter, but yet, we ignore them, for the most part, in mainstream economics…much to the detriment of society.

Reference

Greif, A. (1994). Cultural beliefs and the organization of society: A historical and theoretical reflection on collectivist and individualist societies. Journal of Political Economy, 102, 5, 912-950.

 

Steve

SRN-LogoMark-Green-FORWEB

Blind Pursuit of the Free Market Does not Lead to Prosperity

While I think the perfectly competitive model as it is presented in economics has some uses in helping us understand economic behavior, I believe the way it is presented in economics classes has lead to a vast misunderstanding of the workings of the economy. The presentation typically gives the impression that government intervention in the economy is only bad, except for instances where market failures exist. The problem, in my opinion, is that very little attention is given to the assumptions necessary to make the model work. Sure, these are most often covered quickly at the beginning of the presentation of the model, but the rest of the course or discussion of this model is spent showing who this leads to equilibrium in the markets and how government intervention pulls the market away from this equilibrium and leads to a loss of welfare. However, if one stops and thinks about it, the assumptions of the model (e.g., economic agents act rationally, perfect information, perfectly mobile resources) mean that the free market really never exists. By its very inherent nature, market failure is always present, and because of this and the fact that markets and the economy are huge complex systems, not the isolated static mechanisms of the perfectly competitive model, they are rarely, if ever, in equilibrium.

I want to stress again that there are still some valuable lessons that can be taken from the perfectly competitive model. It is an elegant model that lead to some intoxicating conclusions, but because of this and the lack of emphasis of the assumptions underlying the model, it has lead to a lot of misguided economic policy. This is especially the case with respect to macroeconomic policy, which has been misguided by the absurd dynamic stochastic general equilibrium model. This has lead to the belief by many that all regulations and government intervention are bad and that if we would only get rid of almost all regulations, cut taxes, and minimize the size of government, markets would be able to operate freely leading to more prosperity and a better society.

To be clear, I am not arguing that government is the answer to everything, nor am I arguing that we should raise taxes to exorbitant levels. But, this blind pursuit of the free market based on the misapplication of economic theory or just bad economic theory does not lead to prosperity either. There has to be a balance between the two. Even Adam Smith (one of the greatest, if not the greatest, political economists, to have ever lived), whose Wealth of Nations is the standard bearer for all those in blind pursuit of the free market, recognized the need for balance, as he thoroughly discussed in his Theory of Moral Sentiments.

This has lead to the belief that the ideas of cutting taxes (mostly for those in the upper income strata and the wealthy) and shrinking the government will lead to prosperity and improved social outcomes. Two articles recently published in the New York Times provide even more evidence that this is not the case. One of the articles was written by two political science professors, Jacob S. Hacker of Yale University and Paul Pierson at the University of California, Berkeley. The article, “The Path to Prosperity Is Blue,” is a brief summary of their book, American Amnesia: How the War on Government Led Us to Forget What Made America ProsperI think the following quote from the article summarizes their argument.

Mr. Trump and House Speaker Paul Ryan are united by the conviction that cutting taxes – especially on corporations and the wealthy – is what drives growth.

A look at the states, however, suggests that they’re wrong. Red states dominated by Republicans embrace cut and extract. Blue states dominated by Democrats do much more to maintain their investments in education, infrastructure, urban quality of life and human services – investments typically financed through more progressive state and local taxes. And despite what you have heard, blue states are generally doing better.

Work by Jon Bakija, Lane Kenworthy, Peter Lindert, and Jeff Madrick in their book, How Big Should Our Government Be?provides some evidence against the argument that small government facilitates economic growth. They show evidence that there is a direct relationship between the growth of government and economic growth. Over the past fifty years, those countries where governments have grown the largest over the  past fifty years have also experienced some of the fastest economic growth (see the chart here).

While governments are certainly not perfect, and as I have already mentioned, government is not the answer to every issue or problem, but it seems clear to me that government has an important role to play in the proper functioning of an economy and society. Blind pursuit of the neoclassical notion of the free market with the wildly unrealistic assumptions at its foundation can be very appealing, but it leads to bad economic policy in many cases.

SN logo no name