Review 5: Institutional Economics: Social Order and Public Policy by Wolfgang Kasper and Manfred E. Streit (1998)

Radnitzky, Gerard,
University of Trier, Germany,
Economic Affairs, Vol. 19, No. 4 (December 1999)

"In recent decades it has been more widely realized that human knowledge is limited, always incomplete and fallible, and that social action often produces unforeseen and deleterious side-effects. This insight has, for example, influenced environmental policies. Thus, it is now widely accepted that tangling with nature may produce consequences that no one foresaw.

In economic and social affairs, similar concerns have not yet had much impact. But a growing number of economists have turned away from the neoclassical paradigm, which is based on the assumption of ‘perfect knowledge’ and which inspires confident intervention. Instead, they have developed Austrian, public choice, evolutionary or institutional paradigms of economics, all of which caution about the side-effects of resolute, but ignorant social engineering.

As far as this reviewer is aware, no introductory text is available which makes this kind of economics readily teachable, despite a flourishing specialist literature. This gap has now been filled by the Kasper-Streit book. The two authors build their text on the fundamental insight that rules of conduct whose violations carry sanctions – institutions – are crucial to the effective exploration and co-ordination of limited productive knowledge. Institutional quality and industrial evolution are seen as the essential driving forces of economic growth in the tradition of Max Weber, Douglass North and Eric Jones. Appropriate institutions not only promote growth, they also serve to reduce social conflicts, thus enhancing security, and they protect spheres of private autonomy, thus promoting liberty.

The book discusses the functions of internal institutions (such as conventions, customs, ethical norms, and commercial practices), many of which are self-enforcing, and external institutions (such as made law and administrative regulations), which support and enforce the internal institutions, but which frequently work with high monitoring and enforcement costs. The book draws on Bruno Leoni and Friedrich Hayek to show the importance of universal institutions, that is, non-discriminatory, open and abstract rules to constrain opportunistic instincts and the arbitrary rule of fallible men. It also discusses human motivation, showing how bizarre it is for mainstream economics to assume that Homo economicus always maximizes the attainment of known ends by known means. Entrepreneurial action to explore the unknown is discussed as entirely rational, even though it falls outside the narrow end – means rationality of neoclassical economics.

The main definitions of institutional economics are spelled out concisely in boxes which are interspersed in the text and which the reader can easily find again with the help of a detailed index.

The introduction to basic institutional theory in Part I of the book could serve a course in jurisprudence, political science or sociology just as well as a course in economics. It highlights the common ground of social science that most economists (with the honourable exception of most of those contributing to Economic Affairs) have forsaken for abstract, formalistic and ultimately empty models, a development lamented by a growing number of observers.¹

In Part II, Kasper and Streit apply institutional theory to a thorough discussion of property rights, not only private property, but also club goods and socialized ownership and discuss the great advantages of private property in solving most economic tasks. They then show how important it is for prosperity that property owners compete, time and again, and that they should be able to maintain their wealth only if they compete. Competition is presented in terms of Austrian economics, namely as a discovery process in which property owners incur knowledge-search costs. Since this is burdensome and uncertain, many try to avoid the costs and risks by seeking collective, political protection (rent-seeking). In subsequent chapters, the book discusses the pros and cons of private and collective action, giving a concise and forceful introduction to modern public choice theory, and turns to international economics, highlighting the importance of openness and the role of private institutions in facilitating international exchanges (Law Merchant)

The final chapters discuss the experience and ultimate failure of socialism from the standpoint of institutional economics, going back to the famous Mises-Lange debate of the 1930s, and underline the need for institutional reforms in mixed economies. The Asian economic crisis is attributed to institutional deficiencies (corruption, poor governance, selective industry policies). There are fascinating short accounts of how Germany moved from the postwar market economy to a cumbersome welfare state, and how New Zealand threw out the failing institutions of collective action to adopt a much more capitalist rule system.

Surprisingly little is said about the stifling institutional changes of the European Union since Maastricht.

The book makes for enjoyable and easy reading. It shows the lecturing experience, knowledge of the literature and scholarship of two mature academics. Each chapter ends with challenging questions for revision, and there is a detailed bibliography for those whose appetites have been whetted for more institutional economics.

It is to be hoped that this excellent and innovative book will find a wide readership to cure the next generation of the facile and misleading models of contemporary economics. An obstacle to this end mat well be the high price of the book. The publishers should be encouraged to offer a softcover version for the mass student market. The topic area covered by Kasper and Streit seems far too important to be locked away in specialist libraries and on the shelves of affluent, elderly people.

¹M. Blaug (1997) ‘Ugly Currents in Modern Economics’, Policy Options, 17, 7, 2-5; and F.M. Machovec (1998) ‘Paradigm Lost: The Walrasian Destruction of the Classical Conception of the Market”, in G. Eliasson and C. Green (eds.), Microfoundations of Economic Growth, Ann Arbor, MI: University of Michigan Press, pp. 29-56. "