Institutions, Efficiency, and the Theory of Economic Policy

Author(s): JOHN EATWELL

Source: Social Research, Vol. 61, No. 1 (SPRING 1994), pp. 35-53
Published by: New School
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Institutions,
Efficiency, /
and theTheory /
ofEconomic /
Policy / BY JOHN EATWELL

Introduction

JlLconomics is meantto be useful.Of course,someeconomics

consistsof provingtheoremsderivedfromextremely abstract
models which seem to have no contactwith realityat all.
Equally, some economics consistsof exercises which are
designedsolelyto advance theoreticalor econometrictech-
nique. But, fundamentally, all this work is supposed to be
geared to the dual task of buildinga betterunderstanding of
economic phenomena,and therebydetermininghow eco-
nomicgoals can be betterachieved.Economicsis ultimately
aboutthedesignof efficient economicpolicies.
If "usefulness"and "efficiency" are the objectivesof the
discipline,then the relativesuccessof economicsat any one
timemightreasonablybejudged byhownearlyeconomicgoals
are being met. Withunemployment in the OECD countries
approaching levelsnot seen since the 1930s,povertyincreasing
in many advanced industrialcountries,virtual economic
collapsein the "transition" economiesof Centraland Eastern
Europe, stagnation in much of the Third World (and
sub-SaharanAfricain terribledecline),and withno coherent,
broadlyacceptable set of economic policies to rightthese
economicwrongs,economicsis in a bad way.
Such harshjudgementmightbe deemed unfair.Afterall, it

SOCIAL RESEARCH, Vol. 61, No. 1 (Spring1994)

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36 SOCIAL RESEARCH

is politicians who make policy, not economists. Politicians

adopt arguments which suit their political purposes and
discard ideas which suggest the need for what are deemed
"politicallyimpossible"measures. They and otherpolicymakers
are forced to operate with a broad-brush. They need a "Big
Idea." The subtleties,which to the economist may be the very
essence of an argument,are swept aside by the necessitynot
just of presentinga comprehensibleargumentto the public but
also, and perhaps more importantly,defining a small set of
simple propositionswhichdefine the directionand boundaries
of action within the machinery of government. It was this
requirementwhich led, in the early 1980s, to policy making in
the world's most powerfuleconomybeing nominallyguided by
a curve that Arthur Laffer drew on a dinner napkin.1
However good the economist'sideas mightbe, theycannot be
forced into the policy making arena by the power of either
theoreticalor empirical argument. The ideas have to meet a
perceived policyneed. They have to flowwiththe spiritof the
times.
That does not mean that the economists can be absolved
from any responsibilityfor the evident failure of economic
policy in so many parts of the world. When things are not
going well, policy makers and opinion formers(the bearers of
the conventionalwisdom) are always desperate for new ideas.
They can be readilyinfluencedby schemes which hold out the
promise of "working." Presented with coherent, practical,
broadly supported, and convincingarguments,theyare liable
to accept them.
I want to argue thatit is at thislevel thateconomics is failing
today. It is failingnot because some economists'ideas are not
informing economic policy. They are, and they are not
working.Rather, it is failingbecause economics today is built
upon theoreticalfoundationswhichexclude the verysubstance
of economic policy,namely,the economic institutionsthrough
whicheconomic lifeis actuallylived. This is not to suggestthat
economic thinkingshould be confinedto pragmaticinstitution-

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 ECONOMIC POLICY 37

alism.On the contrary,I willargue thatwhatis needed is a

body of pure economic theorywhich in its very core is
concrete,not, as is the case today,an economic
historically
theorywhich either ignores institutions or treatsthem as
imperfections.

Marketsand Efficiency

At the mostgeneralabstractlevel,moderneconomicsdoes
presentthe policymaker witha single coherentargument.
Underpinning virtuallyall thinkingon economicpolicyis the
idea that marketsare efficient.This propositionis more
pervasivetodaythanat any timesinceit fellintodisreputein
thelate 1930s.Despiteenormousdifferences in interpretation
and application,itis thecentralbeliefof mosteconomists, and
indeedof mostbankers,industrialists, and
politicians, "practi-
cal" people, too. It formsthe intellectualfoundationsof the
economicpoliciesadvancedby democraticpartieson boththe
right and the left of the political spectrum.Yet those
intellectualfoundationsare farfromsecure.
The coreeconomicpropositionin thetheoryof socialchoice
(and hence the theoryof economicpolicy)is thatequilibrium
in a perfectlycompetitive economyis Paretooptimal;thatis,in
a specificand verylimitedsense,it is efficient. The Paretian
definitionof efficiency- thatno individual'spositioncan be
improved without a deteriorationin the positionof someone
else-while it eschewsall considerationof the distributionof
income(Pareto"optima"maybe associatedwitha combination
of great richesand grindingpoverty),nonethelessgoes far
beyond the pragmaticand persuasive idea that markets
encourageefficiency byrewardingtheproductiveand punish-
ing the lethargic.The Paretoprinciplesuggeststhatresources
are allocated, for instance,as between consumptionand
investmentor between education and the productionof
gamblingmachines,in a mannerwhichaccordswiththeutility

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38 SOCIAL RESEARCH

maximizing choices of individuals expressed through their

choices in the marketplace.
The bond between efficiencyand marketsis provided by the
firstpart of the Fundamental Theorem of Welfare Economics,
whichdemonstratesthatfree marketcompetitiveequilibria are
Pareto optimal.This is a persuasive and powerfulidea.2 It may
have major theoretical limitations;for example, neither the
proof of competitive equilibrium nor the Fundamental
Theorem are robust- variations in the underlying assump-
tions lead not to an argument of greater complexitybut to
collapse. But, nonetheless, the Theorem ensures that when
tacklingpractical problems economists require overwhelming
proof if they are to accept that the marketsthey are dealing
with happen to be inefficient.In the absence of proof, they
confidentlybelieve the opposite.

Marketsand Institutions

However,the linkbetweenthe FundamentalTheoremand

policymakingis more tenuousthan it mightat firstappear.
For whenitcomesto theapplicationof theresult,it is unclear
what "a market,"let alone "a free market,"actuallyis. The
marketof the Theorem has no institutional structure.It
consistsof an infinityof infinitesimally small individuals
at
trading prices which emerge out of theether.The perfectly
competitive zone. Models of
equilibriumis an institution-free
marketefficiency typicallycontainno analysisof the institu-
tionswhichmustdefinethe marketplace. Actualmarketsare
and the origins,particularhistories,
composedof institutions,
and structureof those institutionsdefine the way that the
marketoperates. The marketeconomy of Germany,for
example,is quite differentfromthe marketeconomyof the
UnitedStates,whichin turnis quitedifferentfromthemarket
economyof Japan,let alone the "markets" in the transition
economiesof the formercommuniststates.And economic

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 ECONOMIC POLICY 39

policyis necessarilyan exercisein the analysis,design,and

behavior of institutions, including,most importantly, the
behaviorof thestate.
There have been a number of attemptsat creatingan
economicsof institutions. The mostrecenthas been the "new
politicaleconomy"developedin the 1980s,whichprovidesa
theoryof the efficiency of institutions them
by characterizing
as the agglomeration of individualutilitymaximizingchoices
and, hence, subject to traditionalwelfare analysis.These
exercisesessentiallydefineand evaluateinstitutions fromthe
perspective of a pre-ordained, abstract"free market,"while
failingto explainwhattheinstitutionalexpressionof thatprior
free marketmightbe. Simplyarguingthat institutions are
themselves createdby marketsjust adds anotherlayerto the
analysis.The new alliancebetweeneconomicanalysisand the
lawwhichhas burgeonedin thepasttwodecades suffersfrom
similardifficulties.

Game Theory

An alternative approachto the concreteanalysisof market

behaviorhas been providedby recentapplicationsof game
theory.The upsurge of interestin game theoryhas trans-
formedeconomictheoryin the past decade despitethe fact
thatverylittlethatis fundamentallynewhas been added to the
of
insights von Neumann and Morgenstern's
Theoryand Games
and EconomicBehavior,publishedin 1944. The paradox is
explained by the fact that the turn to game theorywas
motivated by theexhaustionof the developmentof Walrasian
generalequilibriumtheory.By the mid-1970s,it was evident
that the Walrasian approach could not be satisfactorily
generalizedoutsidetherealmof perfectly competitiveequilib-
rium.Incorporation of imperfect
marketsand of institutional
whichbore even a fleetingresemblanceto "actual"
structures,
markets, could only be accomplishedby making arbitrary

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40 SOCIAL RESEARCH

assumptionson the form of the aggregate outcomes of

individualactions-essentially imposingmathematical require-
mentswhichhave littleor no economicjustification.Game
theoryseemed to presenta way out of this dilemma by
providing,at least in the form of mixed strategiesand
repeated games, solution concepts which could deal with
institutionsand appeared to have some generality.
Unfortunately, this initial promise remains unfulfilled.
Generality is the last thingwhichthe game theoryrevolution
has produced. Instead, game theoreticapplicationshave
produceda plethoraof modelsand examplesbut virtually no
general solutions.Results depend upon hypothesesmade
about the order of play, the precise solutionconcept,the
numberof players,and so on. This is finefor producinga
"cookbook" of results but less helpful in the design of
economicpolicy.Indeed, it mightbe arguedthatgame theory
has reinforcedthe retreatof economistsfromthe economic
policyratherthan,as was hoped at first,bringingeconomics
closerto "thereal world."
So the attemptto be useful is still dominated by the
traditionaltheoryof markets, eventhoughthedevelopment of
economicpolicyshouldofnecessity incorporatetheinstitutions
in termsof whichpolicymustultimately be expressed.

and Efficiency
Ownership

It is hardlysurprisingthatthosewhosepoliticalgoal it is to
diminishtherole of government findreadyacademicsupport
fortheirviewthatmarketsare moreefficient thanthestate.If
freemarketsare indeedefficient, ofthestate
thentheactivities
shouldnotonlybe at a minimum, but such publicbureaucra-
cies as are necessaryshouldbe subjectto "markettesting."In
recentyears,an importantaspectof the attemptto translate
thatvisionof marketefficiency intoconcretepolicyhas been
theattentionpaid to institutional
design.

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 ECONOMIC POLICY 41

posed by thistaskhave been evidentin the

The difficulties
developmentof an economicsof privatization. Privatization
was in the firstinstanceessentiallya politicallymotivated
program,drivenmoreby the need to findnew waysto fund
fiscaldeficitsthan by any clear conceptionof how it might
promoteeconomicefficiency. The justification in termsof a
neweconomicsof ownershipcame later.
Pure economictheoryactuallyhas littleto say about the
ownershipof firms.It is more concernedwiththe relation-
ship betweenperformanceand the degree of competitionin
the marketsin whichtheyoperate. In the 1950s and 1960s,
what were then called "new" theoriesof the firmanalyzed
the behaviorof corporationsas financialorganismsin which
ownership(in the hands of shareholdersor principals)was
separatedfromcontrol(in the hands of salariedmanagersor
agents). In the absence of competitiveproduct markets,
attentionwas focusedon the role of corporatetakeoversas
the means by whichowners,via a competitive stockmarket,
mightimpose their on
objectives managers. This is still a
flourishingfield of research, especially among finance
economists.The results are inconclusive.Recently,the
argumenthas shiftedsomewhatfromwhetherthe takeover
mechanism"disciplines"managersto whetherit would result
in efficient
long-term outcomes,even if it did providemarket
discipline.The relativeeconomicsuccessof the Germanand
Japanese economies, in which structuresof corporate
ownershipare such thathostiletakeoveris almostimpossible,
suggeststhatthe pressureto produceoutcomeswhichbolster
stockvalues in activestockmarketsmay forcemanagersto
pursue excessively"short-term" goals, neglectinginvestment
in trainingor researchand development, bothof whichtend
to have a longertermpayoff.
Questionssuchas theseare partof themassiveinfusionover
the past decade of financetheory,finance-driven economet-
rics,and the statistical
analysisof financialmarkets into the
economic mainstream.Built upon the foundationsof the

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42 SOCIAL RESEARCH

efficientmarkethypothesis and thecapitalassetpricingmodel

and stimulated bytheincreasingderegulationof domesticand
internationalfinancialmarkets, theeconomicsof financeis no
longerconcernedonlywiththebehaviorof financialmarkets.
It is now the startingpoint of new theoriesof corporate
behaviorand, hence, new theoriesof marketsand of the
operationof theeconomyas a whole.The mainimpactso far
has been on analysesof the interactionbetweenfinancial
marketsand the performance of firmsand, in macroeconom-
ics, on the studyof the behaviorof the foreignexchange
markets.More general models,incorporatinggeneral price
and outputdetermination and the theoryof macroeconomic
policy,have notas yetmade anysignificant impact.
Importantthough all these developmentshave been, none
of them have produced a satisfactory resolutionof the
question as to what forms of ownership mostefficient
are (as
opposed, that is, to what forms of competition are most
whatare the respectiveroles of publicand private
efficient),
ownership,and how ownership patterns might best be
changed to achieve desired outcomes.Economicanalysisis
not providingany clear cut criteriafor the vital decisions
whichmust be made on the transformation of institutions.
What criteriashould, for example, define the role of the
state in the operation of an efficienthealth-caresystem?
Whatcriteriashouldbe used in thedesignof the structure of
privatizedindustries?Similarly,what criteriashould inform
the design of the new marketinstitutions of the former
communist countries of Central and Eastern Europe?
Answeringany of these questionsrequires the recognition
that there is no such thing as the market,and that the
efficiencyof a marketdepends cruciallyon the institutional
arrangements of whichit is comprised.Economistsstilltend
to judge each and everyinstitutional structureagainst the
mythicalcriterionof the perfectmarket,whichhas nothing
to say about institutions.

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 ECONOMIC POLICY 43

A MarketTheoryof theActivistState

The liberaland social-democratic partieswhichmakeup the

progressive wing of democratic politicsin theOECD countries
and who advocate a more active role for governmentalso
typicallybase theirargumentson the presumedefficiency of
markets.Theircase foran economicroleof government is the
presenceof "market failure."That failure is usually attributed
to theimpactofexternaleffects on a competitive marketwhich
result,forexample, in the under provision trainingor lead
of
to theproblemsassociatedwithappropriating thedue rewards
of investment in researchand development.The government
shouldstepin to repairthemarketfailure.In otherwords,the
case foractivistgovernment is made in termsof the need to
imitate the mythicalmarketsof competitiveequilibrium.
Recently, thetraditional analysisofexternalities has been given
freshacademicand politicalprominencein the development
of the"newgrowththeory."
The new growththeoryis essentially theold growththeory.
It is based on RobertSolow's aggregateproductionfunction
models of the 1950s and 1960s, to whichhave been added
variablesrepresenting investment in educationand in research
and developmentand the assumptionthatthereare "increas-
ingreturns"to investment itself.Cross-section studiesindicate
thathighersavingsrationsare notonlyassociatedwithhigher
capital-labor ratios(as the old theorywould predict)but with
higher rates of growth(whichit would not). Characterizing
theseresultsin termsof externalities thenprovidesa rationale
foractivegovernment to provideor to subsidizeprovisionof
education and research, or to offer fiscal subsidies to
investment to encourageactionwhichwillyieldthebenefitsof
increasing returns. The actionsof the state are, therefore,
defined by the needs of the market and acquire their
legitimacy fromthatdefinition.
The policy stance derived from the applicationof the
assumptionof increasingreturnsto internationaltrade has

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44 SOCIAL RESEARCH

been moreambiguous.The standardtheoremsdemonstrating

theadvantagesof freetradeare based upon the presumption
of constantreturnsto scale. Once generalincreasingreturns
are admitted,the resultsof thosetheoremsbreakdown,and
thereis no longeranypresumption in favorof freetrade.The
impactof increasingreturnshas traditionallybeen confinedto
the"infant-industryargument," in which the beneficialeffects
of protectionare admittedwhena backwardcountryneeds to
buildup itsindustrial
base to a levelwhichcan competeon the
worldstage. But in recentyearsthe "new trade theory"has
generalizedthe presenceof increasingreturnsto all levelsof
industrialdevelopment.The factthatin thesecircumstances
therecan be no theoretical
presumption in favorof freetrade
has not, however,been extendedto the design of economic
policy.Certainlytherehas been no widespreadquestioningof
the simplisticfree trade doctrinesespoused (though not
practiced)by the major industrialeconomies.The interna-
suchas theGATT, the IMF, and theWorld
tionalinstitutions
Bank are stilldominatedby simplistic freetradearguments.

Equalityand Efficiency

One of the mostpowerfulinstitutional reformsof the past

decade,whichwas supposedlyinformedbyeconomicanalysis,
was the significant dismantlingof institutions dedicated to
increasingsocialequality.
The espousal of free-market "monetarist"policiesby the
Americanand Britishgovernments of the 1980swas accompa-
nied by major changesin the structureof personaltaxation.
Taxes were reduced for the betteroff while social security
benefitsfor the poor were cut. At the same time,access to
education,health-care, child-care,and a wide range of other
components of a family'sstandardof livinghas become less
and less egalitarian.The case forthesechangeswas made in
termsof economicefficiency. Equality,it was argued,is not

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 ECONOMIC POLICY 45

efficient.Or, as J.K. Galbraithironicallycharacterizedthe

policy,to make the rich work harder theyshould be given
more;to makethepoor workhardertheyshouldbe givenless.
The resultsin terms of income distributionhave been
dramatic.In Britain,forexample,the incomesof the poorest
fifthof thepopulationare lowertodayin real termsthanthey
were in 1979, even though on average real incomes have
increasedby about 30 percent.Virtuallyall the gain has been
concentrated in thetop decileof theincomedistribution.
The idea that equityis the enemy of efficiency, though
widely believed, actuallyfinds no support in economic theory.
Certainlyorthodoxneoclassicaltheorydoes not provideany
justificationfor inequality.The only coherentdefinitionof
efficiency,Pareto Optimality, says nothingwhatsoeverabout
thedistribution of income.Indeed thatis usuallytoutedas one
of itsmajorweaknesses.
This is true not just of orthodox models of resource
allocation.It is equally true in intertemporalmodels and
growthmodels whichmightbe used to analyze the relative
efficiency of differentpatternsof accumulation.Whateverthe
rateof accumulationimplicitin the solutionof intertemporal
equilibriummightbe, it is efficient in Paretianterms(so long,
of course, as all the assumptionsrequired to establisha
competitive equilibriumare in place as the firstpart of the
FundamentalTheorem of WelfareEconomicsrequires).The
typicaldynamiccase for inequality,thatredistribution away
fromprofitswilllead to a slowerrateof growthor to less risk
taking,is meaninglessas a statementabout efficiency. If a
competitiveequilibrium is a no-growthequilibrium, then
no-growth is Paretoefficient,and thatis all thatcan be said.
Of course,all theseargumentsformarketefficiency depend
on therebeing perfectmarkets.So the impoverishedchild
shouldbe able to borrowin a perfectcapitalmarketto send
himselfor herselfto Amherstor Smithand on to Harvardin
theconfident expectationof a streamof lifetime incomewhich
would make the investment worthwhile. Once it is admitted

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46 SOCIAL RESEARCH

thatmarketsare not perfect,then considerablesecond best

problemsarise whichvitiatemoststandardwelfaretheorems.
It is thenonlypossibleto operatewitha simplesocialwelfare
function definingbroadsocialgoals(growth, employment, and
so on ) and to findwhatis therelationship betweenthosegoals
and the distribution of income.Any priceswhichwould be
implicitin a formalsolutionhave no particularsignificance
giventhe absence of perfectcompetition, and, hence, taxes
and subsidieswhichalter pricesare not a prioriefficient or
inefficientexcept in so far as they can be demonstrated to bear
on theattainment of generallyacceptedsocialgoals.
An apparentlyalternativeargumentin favorof inequality
has been put forwardby the so-called"Austrian"libertarians
(the presentday followersof Hayek and von Mises). They
argue thatfreemarketsmaximizeinformation, anyinhibition
to thefreemarketresults competitive seeking,and the
in rent
dynamicsof a competitive marketare moreefficient thanany
manipulatedmarketcan be. They rejectthe staticanalysisof
orthodox neoclassicaltheory.Their position is, however,
severelycompromisedby the factthatit restson presumed
characteristicsof priceswhichcan onlybe provenwithinthe
orthodoxneoclassicalsetting.Therefore,eithertheyare stuck
withthe same limitations as the orthodoxtheory,or, in the
pursuitof the"dynamicsof information," theyhave no theory
of marketswhichcan sustaintheirarguments.
Lacking theoreticalfoundations,the argument on the
relationshipbetweeninequalityand efficiencyhas recently
been widelyaddressed in empiricalwork.The resultshave
typicallyshownthatmore egalitariansocietiesare also more
economically efficient.Equality,broadlydefinedin termsnot
onlyof thedistribution of incomebutalso accessto education,
training, health-care, so on, is associatedwithhigherrates
and
of growth,higherproductivity and employment, as well as
superior social outcomes, such as lower crime rates.Moreover,
the analysisof the interaction of thesevariablessuggeststhat
the causation runningfrom equalityto efficiencyis very

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 ECONOMIC POLICY 47

strong.That is,theintroductionof institutions

whichpromote
equalitywill tend to enhance economic Yet it is
efficiency.
exactlytheincorporationof institutions
intotheargumentsof
economicanalysiswhichhas provento be so problematic.

Institutions
and Pure Theory

This has notalwaysbeen thecase. The institution-less world

is a particular characteristic
of the neoclassicaltheorywhich
dominatesacademicworkand,indeed,virtually all present-day
economicthinking.At the verycore of neoclassicaltheory,
institutionsare imperfections.This was notthecase in classical
theory.It is quite simplyimpossibleto constructRicardo's
theoryof value outsidea specificframework of institutions.
It
just does not make sense withoutparticularstructuresof
ownershipand a "socialand historical"determination of the
"natural" wage. Similarly,the entire corpus of Marx's
economicsis institutionally specific.The theory,be it ever so
abstract,must be located withinconcretehistoricalcircum-
stances.The sameis trueof Keynes'stheoryof employment. It
is simplynot possible to constructKeynes's principle of
effectivedemand outside the institutional frameworkof a
modern capitalisteconomy with fully developed, flexible
financialinstitutions and a government whichissuesmonetary
instruments.
It is importantto notice that in these examples the
characterization of institutionsis withinthe heart of the
theoreticalanalysis.Institutionsare not tacked on to the
pre-determined results.Nor,as is so oftenthecase in modern
institutionaleconomics,are concrete institutionalcircum-
stancesregardedas anathemato formal,abstractreasoning.
The historyof Keynesiananalysisis particularly instructive
in thisrespect.The centralpropositionof Keynes'sGeneral
Theory is thattheeconomymaycome to restin an equilibrium
in whichlaborremainsunemployed.The levelsof activity and

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48 SOCIAL RESEARCH

of employment are determinedby the decisionsof entrepre-

neurs to investand the proportionof theirincome which
individualswish to consume. The flexibilityof modern
financialinstitutionsprovidesentrepreneurs withthe funds
requiredto implement theirinvestment decisions.The volume
of investment, being thus independent the levelof output,
of
determines, via themultiplier, theoveralllevelof expenditure
and incomeand therebythe volume of saving.This is Keynes's
Principleof Effective Demand.
Keynes'sanalysisof the determination of outputis notable
forthe absence of any role for relativeprices.Variationsin
relativeprices, which in neoclassicaltheoryresult in the
clearingof all markets,includingthe labor market,do not
result in the economymovingtoward a full employment
equilibriumin the GeneralTheory. But if in normalcircum-
stances prices do not clear markets,then prices are not
determinedby the relationship betweensupplyand demand.
The entireedificeof neoclassicaltheory,togetherwith its
peculiarportrayalof marketefficiency and its abhorrenceof
must,therefore,
institutions, be false.This was and is a deeply
disturbingconclusion.It is not surprisingthat virtuallythe
entirehistoryof macroeconomics sincethe publicationof the
General Theoryhas been designedto showthatKeynes'sanalysis
was notso radical,thatitis simplya specialcase of neoclassical
theoryattributable to our old friends,marketfailures.Today,
thereis even a "new Keynesianeconomics"whichpropagates
evernew,moretechnically satisfyingmarketfailures.
But Keynes'sneglect of the roleof relativepricesand,hence,
the fundamentalcontradiction betweenhis theoryand the
neoclassicaltheoryof price,output,and employment has been
corroboratedin recentyears by advances in the theoryof
value, notablyin capitaltheory.These formalresults,which
demonstratethatthe standardresultsof neoclassicalcapital
theorydo nothold outsidetheexcessively realmof a
artificial
one-produced-commodity world, have far reaching conse-
quences. They suggest that as applied to an economywith

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 ECONOMIC POLICY 49

produciblemeans of production,not onlyis the proposition

that normal equilibrium prices are determined by the
relationshipbetweensupplyand demand withouttheoretical
foundation,but also the idea that normal competitive
equilibriumcan be associatedwithmarketclearingand full
employment is withoutfoundation, too.
Keynes's analysis of investment, which was essentially
borrowedfromneoclassicaltheory,also falls foul of these
developmentsin capital theory.This leaves the principleof
effectivedemand unscathedbut the questionof the determi-
nation of investment"open." It is clear that a satisfactory
explanationof why Britain and the United States invest
around 17 percentof GDP, Germanyand Francearound 22
percent,and Japan nearly30 percentwillreston a lot more
than simplistic analysesof the rate of returnmightsuggest.
The role of the state,corporateorganization, the relationship
betweenfinanceand industry, industrialstructure,
therateof
technicalprogress,and even the historyof labor relationsall
have a part to play. In other words, the process of
accumulation is a complexinstitutional, and analyti-
historical,
cal problem.The "openness"of Keynes'stheoryof investment
enables the incorporationof these factorsinto the analysis.
Keyneshimselfexcelledin the fusionof all thesedimensions
intohis theoretical narrative.

A TheoryofEconomicPolicy

Keynesprovideda clear and simpleidea- thatthe govern-

mentshouldand couldimplement a fullemployment policyby
a mixtureof fiscaland monetarypolicy.He provided the
analyticaltoolsto do thejob, of whichthe mostimportantis
the multiplierwhich determinesthe impact of spending
decisionson overall activityand employment.The Second
WorldWar and theaftermath of war provideda "spiritof the

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50 SOCIAL RESEARCH

times" conducive to the acceptance and development of

Keynesian ideas.
The practical application of Keynesian analysis was ex-
pressed in a variety of new international and national
institutions.At the level of internationaleconomic policies,the
price mechanism,operating through flexible exchange rates,
was identified as one of the factors which had perpetuated
instabilityand depression in the 1930s. In its place, the 1944
Bretton Woods conference constructeda frameworkof fixed
exchange rates, hedged around with exchange controls,and
added a variety of other measures designed to create an
international environment which was supportive of the
national full employmentpolicies. In the domestic economies
of what was to become the OECD, the state assumed
responsibilityfor the pursuitof full employment.In doing so,
the scale of state activityin the economy increased to levels
never before experienced in peacetime. The success of
monetaryand fiscal policies was now judged in termsof their
impact on the level of employment.Of course, the degree to
which the new policy stance was implemented and the
institutionsit demanded were constructed varied from one
country to another. But what was strikinglynew was the
manner in which the deteriorationof activityand employment
was no longer perceived by policymakersas an inevitableprice
to be paid for the efficientoperation of markets.Instead, the
markethad to operate withinan institutionalframeworkwhich
was dedicated to securing full employmentby the manipula-
tion of the level of effectivedemand.
The years from 1950 to 1970 were a Golden Age of modern
capitalism. All the major capitalist countries grew faster for
longer than they had ever done before and have ever done
since. In the last twentyyears, the OECD countries have not
been able to recover the performance of those years. In
virtuallyall the major countries,trend growthrates have been
at most half the rate of those enjoyed in the Golden Age.
Unemployment has risen, and both national economies and

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 ECONOMIC POLICY 51

the international economyhave become far less stable.The

end of the GoldenAge, theanalysisof whichgoes farbeyond
the scope of thisessay,was heralded by the collapse of the
institutionswhichhad sustainedit.The BrettonWoods system
had gone by 1973. Exchange rates were now floating,and
therewas a rapid growthin the scale of speculativecapital
flows between major currencies,severely restrictingthe
independentscope of monetarypolicyin nationaleconomies.
At the same time,inflationary and fiscalpressureswithinthe
national economies led to the steady dismantlingof the
apparatusof Keynesianemploymentpolicyand its replace-
mentbyan evergreaterrelianceon marketforces.Monetarism
and supply-sideeconomicswere now more in tune withthe
spiritofthetimes.The resultshavebeen notablyunimpressive.
The significanceof thisstoryis not thatthe solutionto the
currentplethoraof economicproblemsis to be found in a
reversionto the institutions and policiesof the 1960s. That
wouldbe highlyimpractical. The worldhas changed.The real
lessonis thateffectiveand successfulpolicymakingrequiresa
mix of sound theoryand concreteinstitutional application.
Keynesiantheoryis not an anti-markettheory.Quite the
contrary,it is a body of theorywhichis located withinthe
actualinstitutionsof whichmarketsare composed.The theory
is abstractbut constructedin termsof concretevariables.As
such, it escapes the circular deductive structureswhich
characterizeneoclassicaltheoryand letsin thelightof history.
Of course,simplyrecognizing theneed to locatetheorywithin
an institutional
contextis notenough.It wouldstillbe possible
to put forwardtheorieswhichwere inadequateor false and
which would lead to inappropriateand even destructive
polices.But demandingthattheoryincorporatean analysisof
institutional
structures at leastmeansthatthe falsedistinction
betweenthe principleson which policy is based and the
institutions
in whichit is implemented is brokendown.
A bitterexampleofthatfalsedistinction has been seen in the
economicpoliciesrecommendedforthe transition economies

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52 SOCIAL RESEARCH

of Central and Eastern Europe. Arguments of astonishing

naivety,based on the belief thatmarketforcescould somehow
be "released" simplyby removing the controllingrole of the
state,have led to widespread collapse and have added greatly
to the sum of human misery. The experience of western
European reconstruction,where investmentand growthwere
carefullyplanned within highly managed market structures
(for example, the Deutsche mark and the pound sterlingdid
not become convertibleuntil 1958, and French reconstruction
was protectedby a wide range of import controls),have been
totallyignored. The rush to a free market has produced the
identificationof democracy with impoverishment.Building a
market economy takes time. Efficient policies in market
economies require powerfulinstitutionsto directand regulate
marketforces.
In the lightof these criteria,the developmentsin economics
in the past decade have not been encouraging. The weaknesses
in neoclassical theorywhich were identifiedin the 1960s and
1970s have not led to a fundamentalreassessmentof economic
theoryor even a returnto earlier ideas which were discarded
prematurely.Instead, there has been a tendency to produce
"cookbooks" of models, each with no wider significancethan
the specificassumptions under which it has been constructed
and each highlysensitiveto any variationin those assumptions.
The search forthatgeneralityof visionwhichcharacterizedthe
success of Keynesiantheoryhas been abandoned. The growing
economic problemsof the 1990s demand a new approach- an
approach that incorporates and validates the institutionalre-
formswhich are necessaryfor policy makers to come to grips
withthose problems.The spiritof the timesdemands thatthe-
oreticaleconomics should become useful again.

Notes

1The "LafferCurve"was drawnto illustrate that

theproposition
wouldreceiveno revenue,and
whentaxesare zero,thegovernment

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 ECONOMIC POLICY 53

when taxes are 100 percent,the governmentwould receive no

revenuesince nobodywould be preparedto undertakeeconomic
just to paytaxes.Therefore,itwas argued,thegovernment's
activity
highestrevenueswould be acquiredat some tax ratebetweenzero
and 100 percent.A propositiondevoidof all meaningful content,it
became (rather unfairly)a symbol of the argumentsof the
"supply-side" economists,who urged tax-cutting budgetson Presi-
dentReagan.
2 the FundamentalTheoremof WelfareEconomics,
Introducing
the authorof a recentpopular and influentialtextbooktold his
readers,"You shouldnowbe hearingchoirsof angelsand choruses
of trumpets. The 'invisiblehand' of the pricemechanismproduces
equilibria cannotbe improvedupon." See David Kreps,A Course
that
in Microeconomic Theory(Princeton,NJ: PrincetonUniversityPress,
1990),p. 200.

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