Chapters 17 and 18
Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Oser Summary Main Page
Chapter 17: The Institutionalist School: Thorstein Veblen
The Institutionalist school began around 1900 after Thorstein Veblen had published his first book, and ended in 1936 when John Maynard Keynes created a more elegant theoretical system. The three main figures in the school were Veblen who was critical of orthodox thinking, Wesley C. Mitchell who stimulated deductive research, and John R. Commons who helped reform the system through government legislation. This chapter is focused on the contributions of Thorstein Veblen, and Chapter 18 covers those of John Commons and Wesley Mitchell.
Overview of the Institutionalist School
The Social Background of the School
Between the Civil War and World War I American capitalism experienced rapid growth and became the largest and most powerful industrial system in the world. While standards of living were rising, the lower income strata did not keep pace. Wage earners worked long hours, lived in inadequate housing, had little if any security for sickness, unemployment, and old age, no access to higher education, and inadequate protection from health and safety regulations. In addition, taxation was regressive, usury was widespread, and frequent depressions were devastating to those who were unemployed. Monopoly was not regulated and political corruption was common. The defense of laissez faire and the status quo as the best possible system had become untenable. Modern capitalism was clearly not conforming to expectations. Out of this environment grew institutional economics. There were two alternative ways to achieve social change: Reorganize society through class struggle, militant unionism, and socialist revolution, or achieve change through social reforms to save rather than overthrow capitalism. The changes made by the New Deal in the 1930s represented the essence of institutionalism.
The Essence of the Institutional School
1. The economy should be studied as a whole, rather than by examining small parts separately in isolation. Economic activity involves patterns of collective action that are more than the sum of the activities of individuals motivated by the desire for maximum individual monetary gain.
2. The school emphasized the role of institutions in the economic system where institutions not only included organizations such as schools, prisons, unions, or banks, but also organized patterns of behavior established and accepted as part of a culture. Examples of patterns of behavior include customs, social habits, laws, traditions and modes of thinking. Beliefs in laissez faire, slavery, unionism, communism, anticommunism, or a government social security system are all institutions. Economic life is regulated by institutions, not by economic laws. Group social behavior and influential thought patterns are more relevant to economic analysis than individual behavior or marginal type theory. The institutionalists were particularly interested in reforming the institutions of credit, monopoly, absentee ownership, labor-management relations, social security, and the distribution of income.
3. The institutionalists used the Darwinian evolutionary approach rather than the static viewpoint that attempted to discover economic truths without considering the changes that were occurring constantly. The relevant questions are "How did we get here, and where are we going?" not "What is?" The evolution and functioning of economic institutions should be studied with a knowledge of economics, history, cultural anthropology, sociology, philosophy, psychology, and social psychology.
4. Recurring maladjustments in economic life such as recessions are not departures from equilibrium, but are normal. Government action is needed to correct these maladjustments.
5. The school rejected the harmony of interest viewpoint and recognized that there were serious conflicts of interest between groups, such as big business versus small business, consumers versus producers, farmers versus city folks, employers versus workers, and importers versus domestic producers. An impartial government must reconcile clashing interests for the common good to insure that the economic system works efficiently.
6. The institutionalists promoted liberal democratic reforms for a more equitable distribution of income and wealth, condemning laissez faire in favor of a larger role for government in economic and social affairs.
7. The school used the inductive rather than the deductive approach, and called for more fact-finding and closer examination of the actual working of the system. Abstract theorizing, particularly by the marginalists was rejected as unrealistic and sterile.
8. The institutionalists replaced the pleasure-pain psychology with more complex psychology incorporating Freudian and behavioristic ideas into their analysis.
What Groups of People did the Institutionalists School Serve or Seek to Serve?
The school represented the needs of small business, labor, and others in an era of growing big business and banker capitalism.
How was the Institutional School Valid, Useful, or Correct in its Time?
Many of their criticisms of orthodox economic theory were valid, and they helped to move economic thinking to a more defensible theory. Their evolutionary approach to analyze the role of institutions in the economic system is also still valid. They also aroused concern over business cycles, and promoted a reform movement that remains relevant today. Their emphasis on inductive research reduced the gap between theory and practice and caught on in government and private non-profit research organizations, labor organizations, and with individual researchers as well. The National Bureau of Economic Research founded by W. C. Mitchell and others in 1920 is a monument to the institutionalists method.
How did the Institutional School Outlive its Usefulness?
The institutional method and viewpoint became part of the economic thinking of many economists, but the vast gathering of facts with a minimum of theorizing was unsatisfactory to those who seek economic laws and use the deductive method. Today the abuses of unrestricted capitalism that were clearly visible in 1900 are constrained by the legal protection of unionism, social insurance, built-in stabilizers, and government responsibility for full employment. People do not agree on the necessity for further changes, or what changes should be made, and how far reforms can go without weakening the incentives to invest.
Veblen
Thorstein Bunde Veblen (1857-1929) is described as a "brooding, enigmatic genius", and "a bitter, skeptical, pessimistic, and lonely man. He was an economics professor who taught at the University of Chicago, Stanford, the University of Missouri, and the New School for Social Research. He had difficulty maintaining an academic position because of his marital problems, his involvements with women, his agnostic views, his indifference to students, and his poor teaching methods. Veblen never became a full professor in spite of his publication record that includes eleven books and numerous articles. He also served as editor of the Journal of Political Economy at Chicago. Although he is considered to be the founder of the institutional school, he was mainly a critic of capitalism, not a reformer. He hoped to see the system superseded entirely, not reformed and saved.
In his first book, The Theory of the Leisure Class published in 1899, he popularized the terms "leisure class," "pecuniary emulations," and "conspicuous consumption," stating that the leisure class was engaged in predatory seizure of goods without working. They consume in a way that displays their wealth to show power, prestige, and success. Women are especially useful, hampered by long fingernails, cumbersome hair styles, that provide constant evidence that they are leisure-class women kept by leisure-class men. Members of the leisure class avoid useful productive work, and must indulge in wasteful useless tasks to remain reputable. The evolution of social structure has been a process of natural selection of institutions, survival of the fittest habits of thought as individuals adapt to changing circumstances. Unfortunately, there is a conflict between current beliefs and current requirements because institutions are products of past circumstances, and are never in full agreement with the requirements of the present. The wealthy leisure class is sheltered from the forces of the environment and embrace the attitude that "whatever is, is right." However, the current institutions are wrong from an evolutionary perspective because they do not change fast enough to be in tune with the times.
Veblen was critical of the marginalist and classical schools. Clark's system (Chapter 13) was essentially based on a deranged static condition. Hedonism turned economic science into a theory of distribution of ownership and income, a folklore or theology to justify private property and the present distribution of wealth and income. Business economics was developed to defend business interests, not the interests of the underlying population and the common good. Veblen was interested in social economics, not price, profit, and ownership.
Veblen thought people wanted to work and to do it well when they were not harassed by overwork. People have an instinct for workmanship, but it conflicts with the conventional antipathy to useful effort. Handicraft production has given way to large-scale capitalistic enterprises focused on machine processing and investment for profit, not the needs of mankind.
Veblen believed the risks to the entrepreneur were negligible stating that the only risks that the technicians cannot overcome are those associated with climate, weather and the occurrence of natural catastrophes.
Credit could be used to increase profits as long as the rate of earnings exceeded the rate of interest. According to Veblen, as the use of credit becomes widespread, aggregate earnings are only slightly higher than they would be without credit, and the rate of profit on the total amount invested is reduced by the amount of interest that has to be paid to creditors. Veblen viewed credit as more of a detraction from the functioning of industrial society because it opened the way to financial manipulation, speculation, increased costs, and greater profits. Credit enables competing businessmen to bid up the prices of capital goods used in industry that serve as collateral for the extension of additional credit. With the cumulative extension of credit, a discrepancy arises between the value of the collateral and the capitalized value of the property based on expected earnings. A period of liquidation begins accompanied by credit cancellations, falling prices, shrinkage of capital, forced sales, and reduced output. Veblen saw chronic depression as normal to business under a fully developed machine industry, but noted that it could be remedied by an increase in the unproductive consumption of goods, as well as through monopoly. Unproductive and wasteful spending by the government (armaments, public edifices, military service, and diplomatic establishments) could also be used, but it would probably be inadequate to offset the surplus productivity of the machine industry.
Veblen was critical of the many conflicts in the system, including conflicts between industry and business, between making products and making money, between the community at large and absentee owners, between the need for social change and the conservatism of people's patterns of thought, between the need for stability and the extension of credit, and between the needs of workers and the profits of employers. Although Veblen was friendly toward socialism, he did not believe socialism was the solution to the problems created by modern large-scale business enterprise. Instead he thought that engineers could create a social revolution and operate industry for the common good. The engineers were viewed as the best representatives of the community at large to promote a smooth working of the industrial system. A soviet or council of technicians could solve the nation's problems, but the chances of this are remote since they are docile and harmless.
Veblen took a dim view of human nature and was not optimistic about the future prospects for humanity. Veblen died in August 1929, a few months before the stock market crash and beginning of the depression that he had predicted.
Chapter 18: The Institutionalist School: Commons and Mitchell
Commons
John Rogers Commons (1862-1945) was a student of economic institutions in action. He attempted to integrate economics, ethics, sociology, psychology, political science, history, and jurisprudence. He took his college classes to visit mental hospitals, law courts, union halls, factories, charitable organizations, and legislative chambers. Commons labeled himself as a socialist, and taught at several colleges, including Wesleyan University, Oberlin, Indiana University, Syracuse University, and the University of Wisconsin. He was an early reformer who advocated an increasing role for government to resolve the conflicts of interests in society so that it could function in an orderly manner. As an advisor to Governor Robert M. La Follette, he wrote Wisconsin's civil service law, a bill that regulated public utilities, and a law combining the aspects of workmen's compensation and accident prevention. In 1921 he advocated that the employer should be financially responsible for unemployment, and it was enacted into law in Wisconsin in 1932. He also helped get a Small Loans Act passed that limited interest to 3.5 percent per month to end "loan shark" evil.
Commons made the conflict of interest rather than the harmony of interest the focus of his institutional economics. The major class conflicts of interest are based on the differences between producers and consumers, and these two groups can be divided into many conflicting classes, such as buyers and sellers, borrowers and lenders, farmers and laborers, and capitalist and landowners. These can be broken into subclasses such as farmers, bankers, manufacturers, merchants, skilled and unskilled laborers, and so on. These groups organize for action according to their economic interests. Conflicts between groups result in a workable harmony of interests or a stalemate. Practical politics and war are used to bring order. The transaction between individuals is the key problem, and transactions include rules of conduct such as rights, duties, liberties, private property, governments, and associations. Economic theory is concerned with the process of economic relations and behavior.
Commons defined an institution as a collective action in control of individual action. The state encourages or protects certain activities and restrains others deemed detrimental to the whole. Collective action is more than control of individual action, it is the means to liberty.
Commons made a distinction between the social and individual points of view. From the social point of view, wealth depends on use values and abundance. From the individual point of view, assets depend on scarcity measured by prices. Capitalism is the process of creating use value for others, and restricting its supply to create scarcity value. This requires two units of measure, the man-hour to measure the quantity of use value created, and the dollar to measure its scarcity value. Commons defended unions, and thought the state exists to rectify the imbalances of power. The courts should protect the worker's property right in his job, just as it protects a businessman's right to a profit. These were advanced views at the time, and Commons was seen as a radical. Today, many of his ideas on social reforms are generally acceptable.
Mitchell
Wesley Clair Mitchell (1874-1948) was one of Veblen's most brilliant students who received a Ph.D. from the University of Chicago summa cum laude in 1899. He taught at Chicago, the University of California, Columbia University, and the New School of Social Research. His most notable work was centered on an analysis of business fluctuations. While Veblen dissected orthodox economic theory, and Commons promoted government intervention, Mitchell added an empirical element to the institutionalists school. He believed his statistical research would provide a better foundation for Veblen's pioneer work and felt that the future of economics was in moving towards more research and less theorizing. Deductive reasoning, according to Mitchell was likely to lead the inquirer astray unless it was checked and corrected by inductive investigation. His The Making and Use of Index Numbers was published by the Bureau of Labor Statistics in 1915 and remained a classic for many years. The National Bureau of Economic Research, which Mitchell founded in 1920 and directed for twenty-five years is perhaps the greatest tribute to his method.
Although the two processes of producing and distributing wealth are interdependent in society, economic theorist have concentrated mostly on the production of wealth. But our most grievous economic problems arise from the frequent imbalance between production and distribution which creates glutted markets of unsold goods and unemployed men and machines. The frequent economic crises and depressions provide evidence that our business system is defective. What is needed is careful social or national planning to overcome the worst features of business fluctuations while preserving economic liberty and security. Mitchell rejected the hedonistic preconceptions of classical and neoclassical economics. He argued that human behavior was a social product, and that major problems could be solved with intelligence and understanding. He defended social planning but said wise social planning must consider both indirect as well as direct effects of social action.
Mitchell's work on business cycles produced four major conclusions.
1. Business fluctuations occur in a money economy.
2. Business cycles are not only fluctuations in aggregate activity, they are also fluctuations that are widely diffused throughout the economy.
3. The ebb and flow of economic activity depends on potential profits, except in a crisis when the rush toward solvency replaces profits as the driving force in the business environment.
4. Business fluctuations are not minor or accidental disruptions of equilibrium, but are instead systematically generated by the economic system.
Business fluctuations are widely diffused throughout the economic system because business enterprises are interdependent. Business firms are bounded together by industrial, commercial, and financial ties so that they cannot prosper or suffer without affecting each other. The growth of credit increases their financial interdependence. Business cycles arise from forces within the economic system as full prosperity gradually breeds a crisis, the crisis merges into depression, deepens for a while, but ultimately begins a new revival of activity and the beginning of a new cycle. During prosperity the slow but sure increase in the cost of doing business occurs as overhead costs rise as new capital investments are made, sticky cost like rent and interest increase, less efficient resources are employed, labor costs rise, productivity declines, and waste increases. Rising costs cause profits to decline as prices cannot be raised in the late stages of prosperity. Declining profits in some industries cause financial difficulties in all industries. Creditors become apprehensive and the pyramiding of credit ends. Demands are made for debtors to pay their debts. A widespread liquidation develops, prices fall, demand for goods declines as expectations of falling prices continues, profits fall, gloom spreads, consumer incomes and spending declines and the economy sinks into a depression.
As the depression drags on, businesses cut waste, inefficient facilities are allowed to stand idle, capital goods wear out or become obsolete, new more efficient lower-cost equipment can be financed at lower interest rates, inventories that have been reduced during depression need to be replenished as business begins to expand, optimism spreads, and the economic system is again on the upswing. Business cycles occur in an economic environment that is gradually and continually changing.
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Go to the next Chapter. Chapter 19: Monetary Economics (Summary)
Go to Chapter 1 and the links to all Chapters. (Summary).
Related summaries:
Martin, J. R. Not dated. A note on comparative economic systems and where our system should be headed. (Note).
Martin, J. R. Not dated. The Beer Game. Management And Accounting Web. (The Beer Game).
Milanovic, B. 2019. Capitalism, Alone: The Future of the System That Rules the World. Harvard University Press. (Summary).
Piketty, T. 2014. Capital in the Twenty-First Century. Belknap Press. (Note and Some Reviews).
Porter, M. E. and M. R. Kramer. 2011. Creating shared value: How to reinvent capitalism and unleash a wave of innovation and growth. Harvard Business Review (January/February): 62-77. (Summary).
Thurow, L. C. 1996. The Future of Capitalism: How Today's Economic Forces Shape Tomorrow's World. William Morrow and Company. (Summary).