The Evolution of Economics: Where We Are and How We Got Here by Peter J

THE LONG TERM VIEW

The Evolution of Economics: Where We Are and How We Got Here By Peter J. Boettke, Peter T. Leeson, and Daniel J. Smith

This paper suggests that contemporary economics is characterized by three key features. First, it is focused on “big questions” in political economy and is willing to look outside economics to search for these questions and their answers. Second, contemporary economics is empirically focused. “Grand theory” has taken a back seat to empirical explorations of institutions in particular. Third, modern economics has been dramatically influenced by “freakonomics”—the application of economic principles to unusual and unorthodox topics—and is increasingly directed at a popular lay audience. We argue that these particular areas of modern economics’ evolution are not unrelated. The development of each key feature is connected to the others.

n the last decade or so, economics has been dramatically altered by the rise of undergone an impressive evolution. “freakonomics”—the application of economic IEconomic principles haven’t changed. But principles to unusual and unorthodox issues. economists’ applications of these principles Freakonomics is characterized not only by its have. There are three key features of contem- provocative applications of economic con- porary economics: cepts, but also by the fact that it is consumable First, economics has refocused its energies by a popular, lay audience, which is increas- on the “big questions” of political economy ingly exposed to the economic way of think- and, closely related, is increasingly turning to ing. insights from other social sciences to search These three trends are not separate and for these questions and their answers. independent evolutions within economics. Second, economics has largely abandoned Rather, they are interrelated in several “grand theorizing” for more empirically- respects. These changes are positive ones for minded projects. Although formalism is still economic science. prominent in economics, increasingly this formalism manifests itself via empirical tech- Economics and the Hourglass niques as opposed to novel theory. In particu- In his excellent paper on the state of econom- lar, the empirical focus of contemporary eco- ics in 1997, David Kreps draws on Paul nomics is driven by the renewed importance Romer’s hourglass analogy to explain the evo- attached to understanding institutions. lution of economics from Adam Smith to the Finally, the face of modern economics has

Peter J. Boettke and Peter T. Leeson are professors in the department of economics at George Mason University. Daniel J. Smith is a graduate research assistant, also in the department of economics at George Mason University. Dr. Leeson can be contacted at [email protected].

14 BOETTKE, LEESON, & SMITH present.1 See Figure 1. even “boundedly rational”) agents respond deterministically to relative price changes to Political Economy & Moral Philosophy, 1776-1900 optimize consumption or production deci- Economics as technical sions, had not yet taken form. Instead of “eco- science & tool of social nomics,” there was “political economy,” in control, 1930-1980 which history, morality, and psychology—in a Economics & political word, “humanity”—was at the center of economy, 1990- analysis. Unlike “economics,” “political economy” Figure 1: The Hourglass Shape of Economics cannot do without these essential, if often intractable, features of the world. To go along In Adam Smith’s day, “economics” was with imperfect and socially-embedded man, part of a much broader social science inquiry classical political economy emphasized the that included and drew heavily upon sister importance of institutions, coping mecha- disciplines such as history, politics, philoso- nisms that emerge to facilitate the ability of phy, and sociology. This is the top of the hour- imperfect actors to coordinate their activities. glass, which is wide, representing the interdis- In creating the “rules of the game” that govern ciplinary nature of economic study and the interaction, institutions were central for those “big picture”-type questions that this study studying political economy because they not asked, most famously, why are some nations only shaped social outcomes, but also because rich while others are poor? they reflected—i.e., were shaped by—social Nowhere is this broad approach more evi- outcomes. The classical political economists dent than in the work of Smith himself.2 Like were thus first and foremost concerned with his fellow Scottish moral philosophers, Smith these institutions and the features of man’s was fundamentally concerned with the con- reality that give rise to them. nections and relationships between morality F. A. Hayek provides perhaps the best sum- and the market. Even in his Wealth of Nations, mary of this tradition and its motivations. As which endeavored to answer a specifically he put it: “economic” question, Smith could not explore Smith’s chief concern was not so this question without thoroughly understand- much with what man might occasion- ing the foundational animating forces of ally achieve when he was at his best human beings, historically and in his own but that he should have as little oppor- time. Those who built in the Smithean tradi- tunity as possible to do harm when he tion, such as J.S. Mill, David Hume, and oth- was at his worst. It would scarcely be ers, also applied this fundamentally interdisci- too much to claim that the main merit plinary approach to economic inquiry. of the individualism which he and his Indeed, it is safe to say that “economics” in contemporaries advocated is that it is a the narrow sense that is used to describe eco- system under which bad men can do nomic study in the mid-20th century did not least harm. It is a social system which exist for these thinkers. Moreover, when does not depend for its functioning on Smith, Hume, or even Mill was writing, the our finding good men for running it, or “marginal revolution” had not yet taken place on all men becoming better than they in economics. A discipline of sterile rational now are, but which makes use of men choice, in which ends and constraints are in all their given variety and complex- taken as given, and perfectly informed (or

15 THE LONG TERM VIEW

ity, sometimes good and sometimes of doing so, the neoclassical presentation of bad, sometimes intelligent and more the logic of choice and the logic of the market often stupid. Their aim was a system also established the use of formal methods— under which it should be possible to mathematics in particular—as the only way of grant freedom to all, instead of analyzing economic problems scientifically. restricting it, as their French contem- Questions of man’s foibles, fears, and stum- poraries wished, to “the good and the bling in his quest to better his condition and wise.” The chief concern of the great exchange with his brethren, let alone the vari- individualist writers was indeed to ety of informal and formal institutions that find a set of institutions by which men defined his environment of choice and inter- could be induced, by their own choice action, simply had to be put aside for reasons and from motives which determined of mathematical tractability. his ordinary conduct, to contribute as At the same time, the marginal revolution much as possible to the need of all oth- operated to sever “economics” from “political ers; and their discovery was that the economy” to a certain extent, or, perhaps system of private property did provide more accurately, to carve out of this social sci- such inducements to a much greater ence mish-mash the peculiarly “economic” extent than had yet been understood.3 elements, allowing them to be distinguished from the historical, philosophical, or psycho- logical elements that were not readily dis- Hayek’s interpretation of classical political posed to analysis using marginal utility theo- economy shows a concern with choosing ry. In this way economics began to pull away man, but one with foibles and fears, who, pre- from other social sciences, something that cisely because of his imperfections, requires was reinforced by the growing methodologi- institutional restraints and filters to steer his cal difference between “scientific econom- activity in a direction to achieve economic ics,” which required formal testable proposi- cooperation and realize the gains from trade tions, and increasingly actually testing these with his fellow man. propositions, in contrast to the historical or

Following WWII, the narrowing of economics greatly accelerated, fueled in no small part by mathematical advances that soon defined what it meant to do “economics” versus other social sciences, which economists increasingly viewed with disdain.

philosophical dimensions of political econo- This picture of the intellectual project of my that were not readily amenable to the classical political economy was transformed application of such methods. Thus, from the into the science of “economics” only as we marginal revolution onward, while ostensibly entered into the 20th century. The marginal more “scientific,” economics also became revolution solved the “diamond/water para- narrower, analogous to the narrowing of the dox” that had so troubled the classical politi- hourglass. cal economists, and later, equilibrium models Following WWII, the narrowing of eco- presented the logic of competitive economic nomics greatly accelerated, fueled in no small forces in a rigorous manner. But in the process part by mathematical advances that soon

16 BOETTKE, LEESON, & SMITH defined what it meant to do “economics” ver- back at the center of economic study. The suc- sus other social sciences, which economists cess of these authors is at least partly respon- increasingly viewed with disdain. The substi- sible for making it fashionable again to tution for Smith’s method of inquiry in 1776, engage in more broad-ranging work, closer to and indeed of the big questions he posed, by classical political economy. models of general competitive equilibrium on Another critically-important figure in the one hand, and technical growth models on enabling this broadening out is Andrei the other, had reached completion by the late Shleifer, whose path-breaking research on 1980s when the hourglass was at its narrow- legal origins, along with several colleagues, est. We had elegant presentations, but some- reintroduced the legal element of political how they failed to capture the essential point economy in discussions of wealth and pover- about the “invisible hand” and the “division ty.4 This important research suggests that the of labor” that Smith saw as the power of the identity of colonizers mattered greatly for market driving the wealth of nations. colonies because it critically shaped what But the decade of the 1990s saw a transfor- kind of legal institutions they received mation of the discipline. The collapse of com- through colonization. British colonies munism and the lingering problems of under- received the common law tradition. French development, in combination with the obvi- colonies, in contrast, received civil law insti- ous fact that excessive formalism had ill pre- tutions. Thus, in Shleifer’s framework, as in pared the best and brightest in the discipline to Smith’s, history plays a vital role—through its understand these two major empirical anom- impact on institutions—in shaping nations’ alies, led to a push to bring into economics ability to prosper. questions of institutional environment (e.g., Like the work considered above, Shleifer’s law and politics) and even cultural factors marks a crucial movement toward the widen- (e.g., ideology, beliefs, social pressures, etc.). ing of the hourglass and points to a path for The hourglass was beginning to widen at its furthering this re-broadened political econom- base again. ic approach that tackles big questions and is In 2000 and 2001, Daron Acemoglu, Simon not afraid to appeal to disciplines outside of Johnson, and James Robinson published two economics to help find their answers. seminal papers that signaled a return to Adam Smith’s “big questions,” using some of Let’s Get Empirical Smith’s modes of answering these questions. The big questions focus of much of contem- Harkening back to Smith’s argument in 1776, porary economics necessitated returning to Acemoglu, Johnson, and Robinson’s work questions about institutions initiated by argued that the institution of private property Smith, as reflected in the work of the authors rights was a critical determination of wealth discussed above. Institutional analysis in turn and poverty. To tell their story, these authors required focus on the empirical reality of the also looked to history. In particular, they economic world. Institutions are important argued that the disease climate in Europe’s ex- because of real-world “imperfections” that colonies shaped the institutions that coloniz- generate problems requiring solution. In fact, ers created in them, which in turn led to eco- it is precisely these real-world imperfections nomic progress or stagnation many years that give rise to institutions in the first place. later. Whether one agrees with this argument In a world in which individuals’ plans are or not, it was central to putting history, insti- already perfectly reconciled—such as the the- tutions, and Smith’s big-questions approach

17 THE LONG TERM VIEW oretical world of Walrasian equilibrium dis- gaining of economic actors in the Smithian cussed below—there is no need for institu- depiction of plan coordination through the tions, and, as such, a central element of reali- market process. As noted above, exchange ty is absent. behavior and the institutions within which The empirical turn in economics is not sole- exchange takes place formed the core of the ly the outcome of returned attention to institu- subject matter for Smith and the classical tions that attended the renewed focus on big political economists. To Smith, a central mys- questions in political economy. To be sure, tery of the discipline was to explain the coor- economics was becoming increasingly empir- dination of the vast division of labor that pro- ical in its approach for many years leading up duces the daily product we take for granted to 1990s. However, the focus on big questions without any central direction, and guided only in political economy and thus institutions by self-interest and profit seeking. The institu- demanded an empirical approach to economic tion of private property and the legal frame- science in ways that earlier 20th-century eco- work that supports it generate the incentives, nomics, unconcerned with such questions, did market prices, and profit and loss accounting not. The reason for this is straightforward. that direct economic actors to specialize in Institutional questions are necessarily ques- production activities and realize gains from tions about how individuals who face prob- trade not only domestically but also interna- lems in the real world cope with those prob- tionally. For Smith, the economic system con- lems. In particular, they are necessarily histor- stituted a complex web of interconnected rela- ical questions about the emergence of such tions between dispersed economic actors. coping mechanisms in the past and their per- Social cooperation under the division of labor sistence to today. produced not only the common woolen coat G.L.S. Shackle dubbed the 1930s “The on the back of the day laborer, but also the Years of High Theory” in economics.5 material progress that was responsible for lift- However accurate his designation is ultimate- ing masses of humanity from abject misery ly judged, there can be little doubt that the and poverty. period between 1950 and 1980 also saw an The formalist rendering of these economic impressive ascendance of mathematical repre- propositions under the auspices of economic sentation of economic theory. In fact, by the theory had to simplify the problem for reasons 1970s, individuals who communicated eco- of mathematical tractability. Rather than nomic arguments in natural language were no explain the reconciliation process, where dis- longer considered theorists. The mathematical equilibrium prices and quantities set in motion advances of the 1960s and 1970s, embedded self-correcting adjustments, the mathematical in the Arrow-Hahn-Debreu model of general treatment of the problem required that the competitive equilibrium, were the starting Walrasian auctioneer posted only the unique point of all economic analysis and advanced price vector that would solve the system of economic training. simultaneous equations. One aspect of the The competitive equilibrium model was vast interconnectedness of the economic sys- intellectually elegant, but its formal rigor was tem was captured in the model, but not the purchased at a high cost in terms of realistic processes of adjustment that coordinated the understanding of the functioning of the eco- interconnectedness—a process that is neces- nomic system. The Walrasian general equilib- sarily facilitated by the institutions discussed rium model substituted the pre-reconciliation by Adam Smith and his successors. of economic plans for the haggling and bar- In the heyday of “grand theory,” then, insti-

18 BOETTKE, LEESON, & SMITH tutions were jettisoned from the discussion by Walrasion world, agents in game theoretic construction. The mathematics employed to models can actually “interact” with one anoth- solve the problem of optimality was not capa- er. Their decisions impact the decisions of ble of explaining adjustment paths, which others, and agents’ self-interest can lead them institutions emerge to facilitate. Indeed, as to try to benefit at others’ expense. In response Joan Robinson had pointed out, in this frame- to the prospect of such opportunism, institu- work, the only way to ensure an equilibrium tions emerge to convert situations of potential solution was to begin in equilibrium.6 conflict into situations of agent cooperation. These heterodox criticisms of general com- The use of game theory for analyzing such petitive equilibrium had little impact on the situations had two important outcomes, both orthodoxy. But theorists from Kenneth Arrow7 of which encouraged increasingly-empirical to Franklin Fisher8 started to admit that unless work in economics. First, with game theory they could provide a plausible story about dis- came the problem of multiple equilibria, equilibrium adjustment paths leading to equi- between which economic theory offered no librium solutions, the entire enterprise of gen- satisfactory way of adjudicating. Only by eral competitive equilibrium possessed limit- appealing to empirical reality was it possible ed relevance. These efforts at developing a in these cases to make the case for one equi- formal theory of disequilibrium adjustments librium over another. Second, in permitting to equilibrium resolution proved to be more some scope for institutions as coping mecha- intellectually cumbersome than desired. nisms, game theory encouraged a focus on the Theory as it was understood between 1950 specific empirical factors that gave rise to par- and 1980 started to lose some of its luster. ticular institutions. Economics as a discipline was confronted This movement in theory coincided with a with a choice: return to an older style of rea- massive decrease in the cost of computing soning within economics to recognize once over time. Mainframe computers were again a variety of behavioral motivations, replaced with desktop computers capable of cognitively limited actors, institutional con- advanced data analysis. In addition to looking tingencies, and historical contexts; or develop to qualitative evidence in history, economists alternative formal representations that were could address their theoretical inconclusive- intellectually more comfortable with non- ness by turning to statistical analysis, which Walrasian settings. While heterodox schools was becoming easier to perform. of thought, such as Post-Keynesianism and A third factor encouraging economists to Old Institutionalism, and more traditional reconsider the importance of institutions, and schools of thought, such as New thus to become more empirically oriented, Institutionalism, Law and Economics, and was the collapse of communism in the late Public Choice, emerged in the 1970s and 1980s and early 1990s. In the 1930s, the 1980s to more prominently argue within the Polish economist Oskar Lange had engaged in economics profession for the older style of a debate with the Austrian economists, reasoning, that choice path was ultimately Ludwig von Mises and F.A. Hayek, over the rejected. possibility of socialist economic planning. Instead, formalism was redirected in a man- Lange’s proposal for market socialism, rooted ner more consistent with discussions about the in the Walrasian framework, was seen at the evolution of various equilibria and the institu- time, and for many years to follow, as having tions that facilitate this evolution using the won the theoretical argument for socialism. tools of game theory. Unlike agents in the Although doubts were raised about the effec-

19 THE LONG TERM VIEW tiveness of socialism during the debate on the ing and teaching to the test, and the impact of grounds of incentive problems that real-world children’s names on their future earnings. socialism was likely to confront, the informa- These topics fall under the rubric of “freako- tional bankruptcy of socialism suggested by nomics,” named after the important work of Mises and Hayek, which they argued was Steven Levitt and his coauthor Stephen rooted in deeper institutional problems of Dubner.10 socialism, was largely rejected. The incredible success of Levitt and The subsequent failure of socialism, pre- Dubner’s book has led to a series of others dicted by Mises and Hayek before WWII, res- written by economists for the general public urrected the deep institutional arguments that attempt to demonstrate the applicability against socialism the Austrians pointed to and of economic reasoning to interesting and demanded that economists reconsider the unusual problems. Economists Robert Frank,

If one takes the core principles of economics to be the most important aspects of the discipline, the freakonomics phenomenon is extremely important not only because it is interesting, but also because it familiarizes non-economists with the most significant concepts in economic science. empirical reality of socialism relative to its Tim Harford, Steve Landsburg, and Tyler theoretical promise, as well as reexamine the Cowen have all added to this burgeoning institutional critique of the Austrians during movement in contemporary economics by the socialist calculation debate that took place providing economic twists on the stuff that decades before. It became obvious, in other makes up our everyday lives. Freakonomics- words, that the institutionally-antiseptic theo- type work is not only fun and insightful—it is ry of the 1950s-1960s had to be replaced by also digestible and in fact is often explicitly an approach that could account for, and directed at a popular audience of non-econo- engage in, comparative institutional analysis. mists. This important trend in contemporary eco- Freakonomics and the Rising Popularity of nomics is highly desirable for several reasons. Economics First, and most obvious, it has allowed the Undergraduate majors in economics have dra- principles of economic reasoning to reach the matically increased since the mid-1990s.9 minds of many more people than traditional Some students have been drawn by the higher academic economic research could achieve. salaries in the field relative to alternative Your uncle will be interested to learn about social science disciplines. But they have also the financial organization of criminal gangs been drawn to economics by the rise of popu- and how most drug dealers barely earn mini- lar works from this discipline that stretch the mum wage. Unless he is an economist, how- insights of economics to unusual topics that ever, he will not be so inclined to learn about students are interested in learning about. This details of the gravity model of bilateral includes, for example, the relationship exchange. If one takes the core principles of between abortion and crime, cheating among economics—incentives, opportunity cost, Japanese sumo wrestlers, standards of learn- unintended consequences, and so on—to be

20 BOETTKE, LEESON, & SMITH the most important aspects of the discipline, offered “big answers” in response. But during the freakonomics phenomenon is extremely the 20th century, the penchant for big ques- important not only because it is interesting, tions was replaced with a striving for formal but also because it familiarizes non-econo- rigor and precision. The idea was seductive. mists with the most significant concepts in Ambiguity in thought, it was argued, results economic science. from using the same words to mean different Second, and closely related, because things, or using different words to mean the freakonomics-type research often targets the same thing. We can overcome this ambiguity public, it depends crucially upon conveying by moving decisively away from natural lan- economic ideas using natural language as guage and instead substituting mathematical opposed to mathematics. It is too early to say, representations. Mathematical modeling com- but the increasing popularity of freakonomics pels us to explicitly state the assumptions may have some effect in pushing economists employed in our constructions. back toward the style of reasoning and analy- Unfortunately, in the name of mathematical sis the classical political economists tractability, economists increasingly narrowed employed. We do not expect natural language the analysis. Not only did the field of econom- to totally supplant the use of formal language ics stop asking the big questions in social the- in the same way that formal language more- ory, it artificially narrowed its scope to such or-less totally supplanted the use of natural an extent that the discipline became more and language in economics in the 20th century. more precise about less and less. The situation However, the freakonomics phenomenon may was unsustainable, and in the past 15 or so at least make it possible to put natural lan- years, the discipline of economics opened guage-style reasoning back on the table as one itself back up to tackle the questions that had of several legitimate modes of scientific eco- defined the field of political economics since nomic discourse. its founding with Adam Smith. If in fact such a movement takes place, eco- As we ended the 20th century and the 21st nomics may open up yet further to explore began, the technical discipline of economics additional aspects of the big questions in was once again transformed into political political economy, which, while critically economy. Spurred in part by the renewed important, are not amenable to formal model- emphasis on the importance of institutions in ing or traditional econometrics, but instead analyzing the big questions of political econo- demand a combination of philosophical and my, in part by the indeterminacy of equilibria historical reasoning of the kind that econom- with the growth of game theory, and in part by ics began with in Adam Smith’s work. the growing ease of quantitative empirical work, economics also witnessed a movement Concluding Remarks in which “grand theory” took a back seat to Modern economics has followed an hour- more empirically-oriented projects that exam- glass-shaped path over the past century. ine the institutional features of the world that Originally a branch of moral philosophy, underlie the rules governing social, political, political economy up through the 19th centu- and economic interactions. ry was a broad-ranging discipline that touched Most recent, as a result of “freakonomics,” upon issues in history, politics, sociology, and there has been a dramatic rise in the populari- philosophy. Political economy asked “big ty of economics as a major on college and uni- questions,” and many political economists versity campuses across the U.S. and a tremendous growth in the public appreciation

21 THE LONG TERM VIEW of the discipline. Hopefully, this transforma- tion will be accompanied by a return to natural language-based analysis in economics, which would allow us to understand in greater detail the array of factors that combine to cre- ate social cooperation and progress.

Endnotes 1 Kreps, David M. (1997). “Economics: The Current Position.” Daedalus 126: 59-86. 2 Smith, Adam (1776) [1937]. An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Modern Library; Smith, Adam (1759) [1982]. The Theory of Moral Sentiments. Indianapolis: Liberty Fund. 3 Hayek, F. A. (1948). Individualism and Economic Order. Chicago: University of Chicago Press. 4 Djankov, Simeon, Rafael La Porta, Florencio Lopez-de- Silanes, and Andrei Shleifer (2003). “Courts.” Quarterly Journal of Economics 118: 453-517; Glaeser, Edward L., and Andrei Shleifer (2002). “Legal Origins.” Quarterly Journal of Economics 117: 1193-1229. 5 Shackle, G.L.S. (1967). The Years of High Theory: Invention and Tradition in Economic Thought, 1926-1939. Cambridge: Cambridge University Press. 6 Robinson, Joan. (1978). “History versus Equilibrium,” in Contributions to Modern Economics. Oxford: Blackwell. 7 Arrow, Kenneth J. (1959). “Toward a Theory of Price Adjustments,” in Moses Abramovitz, ed., The Allocation of Economic Resources: Essays in Honor of Bernard Francis Haley. Stanford: Stanford University Press. 8 Fisher, Franklin M. (1983). Disequilibrium Foundations of Equilibrium Economics. New York: Cambridge University Press. 9 See, http://online.wsj.com/public/article/SB11205297861 6277054-vbmCp8DGminE3fKhMa5zouOt0R4_ 20060705.html?mod=blogs. 11 Levitt, Steven D., and Stephen J. Dubner (2005). Freakonomics: A Rogue Economist Explores the Hidden Side of Everything. New York: William Morrow.