The Decline of Institutional Economics
Institutionalism attained a significant position in American economics in the interwar period, both in academia and in government, but then declined in position and prestige after the Second World War.
At this point institutionalism fell out of the mainstream of American economics to become a heterodox tradition on the margins of the discipline. There are quite a number of overlapping reasons for this, some of which reach back into the 1920s and 1930s, but the focus here will be limited to just a few of the more important issues.Institutionalism clearly did not live up to its own early promise, particularly in its failure to pin down exactly what foundations in modern psychology it was supposed to have. After the mid-1920s, psychologists abandoned the instinct/habit approach in favor of a behaviorism that became increasingly narrow and difficult to see as an adequate foundation for institutional economics. In this climate, the enthusiasm for new psychological approaches that had played such a role in the institutionalist movement’s beginnings could not be sustained. Institutionalism probably played a part in ridding economics of explicitly hedonistic language, but it did not develop the alternative basis to convince the profession as a whole to abandon its traditional views of rationality (Lewin 1996).
It must also be said that institutionalists failed to develop their theories of social norms, technological change, legislative and judicial decision-making, transactions, and forms of business enterprise (apart from issues of ownership and control) much beyond the stage reached by Veblen and Commons. The reasons for this lack of development relate partly to the focus of interwar institutionalists on immediate and pressing policy problems, like business cycles, labor law, and social security. In addition, from the late 1920s on, sociology separated itself from economics and became established in separate departments, taking much of the subject matter of social norms and institutions with it.
It is also the case that, from the 1930s onwards, many new developments in theory and methods occurred within economics, developments that tended to displace institutionalist ideas and methods. Hicks’s revision of demand theory seemed to free economics from the shifting basis of psychology, while the work of Joan Robinson and Edward Chamberlin provided treatments of imperfect competition more amenable to neoclassical approaches. The discussion of externalities in terms of market failure was also much clarified. Neoclassicism developed a language capable of encompassing at least some of the issues of concern to institutionalists; issues that had formerly fallen outside the neoclassical theoretical compass.
Moreover, institutionalist approaches to business cycles were replaced by Keynesian ideas. In many respects, Keynesian economics took over the role of the exciting new economics that institutionalism had played in the early 1920s (Rutherford and DesRoches 2008). In addition, neoclassical and Keynesian economics gained an empirical component with the rise of econometrics. Institutionalists could no longer claim greater “scientific” standing because of their empiricism.
In these ways more orthodox economic theory took over those aspects of institutionalism amenable to “model analysis” (Copeland 1951) while other aspects were absorbed into what became applied field areas, such as industrial organization, labor economics, and industrial relations. At least until the 1960s these field areas had only loose ties to the theoretical core of the discipline, and maintained a substantial institutional component.
All of this was combined with a shift in the view of proper scientific method as applied to economics. Interwar institutionalists had frequently claimed the mantle of science on the basis of an empirical and instrumental view of science taken largely from John Dewey. Over the same period orthodox economists had been much more cautious in their claims to science, but this was to change.
Orthodox economists came to adopt either the logical empiricism of Rudolf Carnap, Carl Hempel and Ernest Nagel, or Friedman’s version of positive economics. Logical empiricism emphasizes the “hypothetico-deductive” nature of theories. Theories contain axioms and statements derived from them. The axioms “may refer to either observables or theoretical entities,” and the “system is given empirical meaningfulness only when the system is given some empirical interpretation” via the translation of some of the theoretical statements into observational language (Caldwell 1982: 25). It is usually the “lower level” deduced consequences of a theory that will describe observables and that are subject to empirical verification. Friedman’s version of instrumentalism is much less formal and simply focuses attention on the testing of a theory’s predictions with no attention being given to the realism of assumptions. Both positions, however, provided a view of science that could counter institutionalist demands for realism. Both gave wide range to deductive theorizing with the emphasis only on the empirical testing (by verification or falsification) of some specific implications of the theoretical model. This gradually displaced the broader institutionalist concern with realism. Logical empiricism, in addition, claimed to be a general description of scientific procedure, applicable to both the natural and physical sciences, and it largely displaced pragmatism as the ruling philosophy of science in the United States. Increasingly, institutionalism was criticized for lacking theory. As one example, Mitchell was accused by Koopmans (1947) of “measurement without theory;” an exaggerated view, but one often repeated and widely accepted.Finally, a significant part of the institutionalist agenda of social reform had come to pass, both removing some of the original causes of the institutionalist movement, and prompting a reaction in the form of critiques of the expanded role for government that institutionalists had done so much to put forward.
Under these circumstances, it is not difficult to see why institutionalism slipped from being a central part of American economics to a more marginalized position. This change did not happen overnight, but was hastened by the significant amount of new hiring on the part of American universities immediately after the Second World War. These new faculties were predominantly Keynesians or neoclassicals equipped with the latest in mathematical and econometric tools. The retirement of the last of the older generation of institutionalists in the 1950s completed the process (Rutherford 2011).